Chris Gaffney

European investors can breathe a sigh of relief after the German constitutional court ruled in favor of the European Stability Mechanism. But their focus will now shift toward the FOMC which begins its two-day meeting this morning. The markets were inspired by the German court’s ruling, and it looks like we will have another ‘risk on’ day in the currency markets. With investors regaining their confidence, commodity markets have also continued their reversal, bringing the commodity-based currencies with them. Lots to talk about today and I have an interview I need to prepare for this morning, so let’s get going.

The euro (EUR) climbed back above $1.29 for the first time since April after Germany’s top constitutional court ruled in favor of the European Stability Mechanism. Technically they didn’t rule on the ESM, but instead dismissed motions filed by groups seeking to block Germany’s participation in the fund. These dismissals were widely expected, but many investors were worried about conditions the court may have decided to place on Germany’s participation. The court did place conditions, but they were the lightest conditions possible, stating a cap of approx. 190 billion euros ($245 billion) be set on German liabilities. The ESM was established as a permanent fund which would offer loans to euro-zone members and can buy their bonds to lower borrowing costs if requested to do so. The fund was established with funding of 500 billion euros, with the largest portion of that funding coming from Germany. The ECB’s recent announcement of unlimited buying of sovereign debt has probably just been capped by the German courts condition, but the markets don’t seem to be worried about that right now. After all, neither Spain nor Italy have asked for a bailout, and the current funding levels are more than sufficient to handle the crisis in Greece.

So one of the two major events of the week is past, and the markets can now focus on the FOMC meeting which began today and will conclude tomorrow. Chairman Bernanke will hold a press conference tomorrow afternoon, and is expected by many to announce another round of bond buying known as ‘quantitative easing’. In addition to more stimulus, the FOMC is expected to let the markets know they will extend the near zero interest rate policy into 2015. The additional stimulus is not a sure thing, as our friends over at Agora’s 5 Min. Forecast stated yesterday.

There has been so much talk about another round of stimulus that I think the FOMC risks sending the stock markets into a serious slide if they don’t announce some sort of stimulus program. And to Dan’s point, just the expectations of another round of stimulus have already sent the stock market and price of crude higher.

But Chairman Bernanke has called the consistently high unemployment here in the US a ‘grave concern’, and last Friday’s poor employment report certainly didn’t do anything to calm his concerns. The US economy is growing, but the rate just isn’t quick enough to offset all of the job losses of the past 4 years. Just before Bernanke’s press conference, the Fed will release policymkers’ forecasts for unemployment, inflation, and the expected path of the Fed Funds rate over the next several years. It will be interesting to see what the consensus reached by the members of the FOMC is regarding these key economic factors.

Moody’s Investor Service fired another warning shot across the bow of the US congress yesterday as it said it may join S&P in downgrading the US credit rating next year. Moody’s pointed to the US debt-to-GDP ratio as being unsustainably high. This is something Chuck has been pointing out for years, with the US debt-to-GDP ratio among the highest of all industrialized countries. Moody’s put the rating under review with a negative outlook in August 2011, the same month S&P cut its AAA rating of the US. Both rating agencies were concerned over the ‘fiscal cliff’ which was established when congress delayed a decision on the Bush era tax cuts and raised the debt limit. At the time, Chuck pointed out that S&P was already late to the party, and now Moody’s is trying to figure a way to bring their ratings in alignment with S&P. But the markets don’t really pay much attention to these rating agencies which lost a boat-load of credibility during the mortgage induced credit crisis of ’08-’09.

Instead of worrying about a future downgrade to the US credit rating, investors have been emboldened by the German court ruling and the possibility of more liquidity supplied by the FOMC. The markets are in a ‘risk on’ mode this morning with the safe havens getting sold and money flowing back into the higher yielding currencies. The New Zealand (NZD) and Australian dollars (AUD) were two of the best performers versus the US dollar yesterday, and they continue to rally this morning. The kiwi also benefitted from a report released by Fitch which confirmed the nation’s AA status, citing its strong central bank and good business environment. Fitch also affirmed their stable outlook for New Zealand’s economy. Currency traders over at BNP Paribas are predicting the kiwi will rise to 84.70 cents according to a note they sent out to their clients yesterday. New Zealand rates are slightly below those in Australia, and therefore probably have some room to rise. While the Australian dollar has come under some technical pressures lately, the kiwi still seems undervalued.

The commodities are also rallying this morning as volatility in expectations for global growth have decreased. Many had said the commodity bull market was over, but obviously it was just taking a bit of a rest. I have been telling anyone who will listen that I firmly believe we are still in a long-term commodity bull market, fueled by growth in the emerging markets (especially China). The commodities have also been propelled higher by all of the fresh stimulus talk. With the world’s two largest central banks looking to pump more stimulus into the global economy, inflation pressures will continue to mount. I know there are many who point to the current inflation readings and say I am just crying wolf, but as I continue to point out, it is a simple question of supply and demand. There is just too much money sloshing around to not eventually lead to inflation. The policies being implemented by the US Fed, ECB, BOE, and BOJ will eventually lead to higher inflation and higher interest rates.

The commodity rally helped both of our neighbors, with the Mexican peso (MXN) moving back below the 13 handle and the Canadian dollar (CAD) strengthened to a 13-month high. The Mexican peso is the best performing currency versus the US dollar this year, appreciating 7.185%. Recent economic data out of Mexico seem to support the currency’s appreciation, with output expanding 4.9% in July. This was the fastest annual pace of appreciation since February. And interest rates are also supporting the Mexican pesos, with the highest real interest rate (rate-inflation) of any of the industrialized nations. Combine these factors with the added stimulus here in the US and the prospects for Mexico are looking good.

As I mentioned earlier, the Canadian dollar has also been rallying. While the Mexican peso has outpaced it, the loonie has still appreciated 4.88% versus the US dollar since the beginning of the year. The Canadian dollar has benefited from a rise in the price of crude oil, which moved back up to challenge its recent highs of $97 per barrel. New unrest in the Middle East, combined with expectations of more global stimulus, has pushed the price of oil higher, and has also helped the Canadian dollar. I think the loonie will also benefit from fund flows out of the US dollar as investors look to diversify their dollar holdings. But the appreciation of the Canadian dollar will probably be capped a bit by the release yesterday of a report which showed Canada’s trade deficit widened due to a drop in crude exports. Canada posted a C$2.34 billion ($2.4 billion) deficit during the month of July, up from a revised deficit of C$1.93 billion in June. The recent rise in the price of crude will probably serve to offset some of this deficit in the coming months, so the report really hasn’t had too much of an impact on the loonie. I think the bigger key for future gains for the Canadian dollar is interest rates. BOC Governor Carney has taken on a hawkish tone, and will likely be raising rates. This is a stark comparison to the ECB and US Fed which continue down very dovish paths. Interest rate differentials will continue to send investors toward the Canadian dollar.

Then there was this. Mike Meyer alerted me to an article in The Economist magazine which pointed out that the US saw another decrease in their Global Competiveness Index score. According to the magazine, the US fell in a competitiveness ranking by the World Economic Forum, reaching seventh place, while Switzerland, Singapore and Finland hold the top three spots. “Plotting the scores against [gross domestic product] per person reveals an unsurprising correlation: competitiveness brings wealth, but rich countries can most easily afford to provide the conditions for it,” according to The Economist. “They can squander competitiveness too.”

To recap… I think I typed Global Stimulus Expectations 15 times this morning, and the markets are definitely expecting another round by the FOMC. The euro continued to rise after the German high court dismissed the challenges to Germany’s participation in the ESM. Our friends at The 5 make a case for a delay in the Fed’s announcement, but that could really upset the markets. Moody’s warned US lawmakers that they will downgrade the US credit rating unless they do something about the debt levels. And the commodity bull market seems to be back, bringing up the commodity based currencies with it.

Chris Gaffney
for The Daily Reckoning

Chris Gaffney

Chris Gaffney is vice president of EverBank World Markets and the alternate author of the popular Daily Pfenning newsletter. Mr. Gaffney has been involved in the global marketplace since 1987, and is director of sales for EverBank World Markets. The Daily Pfennig is delivered via e-mail to tens of thousands of market watchers globally, providing commentary that allows them to stay on top of economic, currency, and market happenings. He is a Chartered Financial Analyst and holds degrees in accounting and finance from Washington University in St. Louis.

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