Fed Splits on Need for More Quantitative Easing

The markets were pretty dull yesterday, with the currency and metals markets trading within a fairly tight range. Data released yesterday morning showed that American consumers increased their spending by more than economists forecast in February. Purchases were up 0.7% for the month, the most since October of last year. But more than half of this gain in spending was due to higher prices as fuel and food prices continued to demand a larger percentage of consumers wages. Luckily incomes also climbed in February, though not as much as spending and below what economists had expected. Yes, the US consumer is going further into debt, just what the government wants, but not very good news for the long-term future of the US. Other reports showed that pending home sales increased just over 2% from last month, but were down 9.3% from a year ago. Today is pretty light on the data front, with the CaseShiller Home price index out this morning and consumer confidence numbers released later. Neither is expected to be much different than last month, and both will likely show that the US economy is still muddling along.

The higher spending seemed to support St. Louis Federal Reserve President James Bullard’s call for a quick end to QE2. But other members of the Fed don’t think an early exit from the latest round of quantitative easing is prudent. Chicago Fed Head Charles Evans was quoted in a Bloomberg news article yesterday countering Bullard’s weekend assault on QE2. “Despite recent improvements to the outlook, we are not yet at the point” when “a change in the stance of monetary policy will be necessary,” Evans said today in a speech in South Carolina. “Slow progress” in lowering unemployment “and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate.”

The Federal Reserve Board of Governors is clearly split on the need for additional stimulus, and the offsetting risk of higher inflation. St Louis’ own Bullard is worried about just how much stimulus the Fed has pumped into the system, and has been sounding the warning bells regarding inflation. But as Chuck has pointed out, Bernanke is clearly on the side of printing as much money as possible to keep the stock jockeys happy, with little regard to inflation risks lurking in the future. QEII has produced what our own Chuck Butler has called the next big bubble: a bond market which is clearly overpriced. The two successive rounds of quantitative easing has meant the Fed is one of the largest buyers of our own debt, which has kept prices of these securities up and interest rates low.

But the Feds’ buying will be ending in June (or sooner if Bullard gets his way). And the Japanese catastrophe could lead another big purchaser of our treasury securities to back away from the table. Japan has traditionally been one of the largest participants in our US treasury auctions. But the Japanese now have dramatic spending needs at home, and will undoubtedly decrease their US treasury purchases over the next few months. Many believe that they will not only decrease their purchases, but may even find the need to sell some of their existing US treasuries in order to pay for the rebuilding of their country. So I expect the two largest purchasers of US debt to be curtailing their purchases in the coming months, which will certainly lead to higher rates in the US. The combination of the end of QE2 and Japan’s rebuilding needs could lead to the popping of what has grown into a major bubble in the US Treasury market.

The euro (EUR) rallied a bit in early European trading on speculation that ECB officials would sound a hawkish tone after a report is expected to show inflation in Germany remains above 2%. ECB council members Jozef Makuch and Yves Mersch are scheduled to speak later today and are expected to talk about the need to raise rates in order to combat rising inflation. Most economists expect that the ECB will increase their main refinancing rate by 25 basis points at their April 7 meeting, and the markets are expecting an additional 50 basis point increase by year end. This is compared to the US where the FOMC is expected to keep rates near zero for the remainder of the year. ECB President Jean-Claude Trichet said yesterday that inflation rates that stick above 2% would be a concern. Interest rate differentials will be working against the US dollar, and barring any other “catastrophes,” the dollar will lose its luster as a safe haven currency. Even with the sovereign debt crisis, interest rate differentials will probably keep a floor under the euro versus the US dollar.

The best performing currency yesterday was a bit of a surprise, as I expected either Canada or Norway to be on top with the recovery of oil prices. But the number one performer versus the US dollar yesterday was the Swiss Franc (CHF) which added to its lead as the best performing currency over the past 12 months. The Swiss franc has solidified its place as a safe haven currency, and is seen by many as the only traditional safe haven left after the G7 intervention weakened the yen (JPY) and the Fed continues to flood the market with dollars. The Swiss National Bank tried to intervene and stop the franc’s appreciation during the European debt crisis last year, but to no avail as the franc gained more than 18% versus the euro.

Now the IMF suggests the Swiss central bank should start raising rates as the Swiss economy heats up. In a statement handed out yesterday, officials at the International Monetary Fund said the SNB “should be in the position to start tightening the policy rate in the near term”. Inflation is still under control in Switzerland, but the IMF believes the current near zero interest rate policy is unsustainable given the recent growth figures. The IMF predicts the Swiss economy will grow at 2.4% rate this year, which is far from growth rates in Asia, but still very respectable for the European continent. But higher interest rates would certainly lead to a higher value for the franc, just what the SNB has been trying to avoid.

The pound sterling (GBP) got some more bad news yesterday as GDP for the previous quarter was reported at just 0.5%, below what economists had expected. Economists are now leaning toward no rate change by the BOE at their next meeting in May, and with the ECB sounding more hawkish, the pound is taking it on the chin.

The carry trade is back, and pushing the Aussie dollar (AUD) back into record territory. With the G7 intervening to keep the Japanese yen down, the carry trade is pretty much a “no brainer”. The yen had run up dramatically after the earthquake as individuals and corporations repatriated funds. But the repatriation moves seem to be over, and investors are now piling back into the carry trade, selling yen and buying the higher yielding currencies. This has pushed the Aussie dollar back up to a new record high versus the US dollar and has also halted the decline of the New Zealand dollar (NZD).

These commodity currencies were also buoyed by reports that are expected to show an increase in exports for New Zealand dollars and higher retail sales in Australia. New Zealand also posted its first trade surplus in eight months in February, a good sign that their economy is rebounding after the catastrophe in Christchurch. Both economies are now rebounding, and now that concern over Japan is beginning to wane, currency investors are back to looking at global growth which should support commodity prices.

The Canadian dollar (CAD) was one of the top performers of the commodity bunch as oil inched closer to a 30-month high. Canada is the largest supplier of crude oil to the US, and with the problems in the Middle East our dependence on the Canadian supply will likely increase. As I mentioned yesterday, Prime Minister Stephen Harper’s government fell over the weekend, so campaigning has begun in earnest for the country’s fourth election in seven years. Political uncertainty is never good for a currency, but the higher oil prices and a fairly robust economy have offset this risk and kept the loonie well bid versus the US dollar.

Gold declined for a fourth day as investor confidence in a global recovery was increased with the higher consumer spending number. The possibility of a quick end to QE2 was also reported to have caused some of the sell-off, as an end to quantitative easing would release some of the inflationary pressures building in the US markets. A hawkish tone from the ECB would add to the negative sentiment regarding the metals, as both gold and silver are still seen as a protection against inflation. But the fighting in Libya isn’t over, and radiation levels around the Japanese nuclear plant have increased to near fatal levels. Uncertainty is still hovering over the markets, so any sell off in the metals could quickly reverse. We continue to suggest all investors keep a portion of their investable assets in metals as a hedge against ‘global uncertainty’.

Recap: Both the currency and metals markets were pretty flat yesterday after data in the US were somewhat mixed. US consumers are spending more, but are also borrowing more to spend, and some of this increase is due to higher prices. We will get inflation data out of Europe today, and ECB members are expected to sound a hawkish tone which will likely support the euro. The best performing currency yesterday, and over the past 12 months, has been the Swiss franc; and there doesn’t seem to be anything preventing it from further appreciation. Commodity currencies have really rebounded from the sell off following the Japanese disaster as the “carry trade” is back in vogue. Gold declined along with silver, but it is still an excellent “uncertainty hedge.”

Chris Gaffney
for The Daily Reckoning