Interesting Times

Good day. These are very interesting times for the new Fed chairman. Bernanke put his inflation-fighting credibility on the line yesterday when he led a majority vote to leave interest rates unchanged, even as consumer price increases quicken. But the FOMC was not unanimous in its decision, with Richmond Fed President Jeffrey Lacker blasting the majority decision. We will have to wait and see just how strong a leader Bernanke is in directing the FOMC through the next few meetings.

Instead of shedding some light on the future direction of rates, the new FOMC statement was fairly vague (so much for Bernanke’s policy of clear disclosures). The statement points to a cooling U.S. economy and inflation risks that are “elevated.” In language added to this month’s statement, the panel predicts pricing pressures will abate because of past Fed moves and “other factors restraining aggregate demand.” Here, for your reading pleasure, is the text of today’s statement:

“Economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices. Readings on core inflation have been elevated in recent months and the high levels of resource utilization and of prices of the energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand. Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

The markets seem as confused as the FOMC about the direction of the U.S. economy, as the dollar dropped dramatically just after the announcement, only to bounce right back up to close the session just over where it started yesterday morning. Overnight, the Asian and European markets decided the accompanying FOMC statement was more dovish than the U.S. markets had thought and the dollar was sold off…again. With a divided Fed, an economy that seems to be slowing, and inflationary pressures rising, the markets will continue to be very volatile – trading up or down on the day’s data releases.

And speaking of data releases, today we already saw the release of MBA mortgage applications, which were surprisingly strong. We will also get wholesale inventories, which are expected to show a rise of just 0.6% for June. The big numbers will be released tomorrow, when we will get the trade balance, weekly jobs data, and monthly budget statement. The “Twin Deficits” will likely show the United States continuing to increase our trade deficits while our budget deficits will narrow slightly due to increased tax revenues. While the narrowing budget deficit is good news, the near-record trade deficit won’t be. As Chuck has been pointing out, the currency markets are putting a premium on the currencies of countries that have a trade/current-account surplus. A widening trade balance in the United States will only feed more fuel to the dollar bears.

More good news out of the United Kingdom overnight, as the Bank of England said U.K. inflation and growth in Europe’s second-largest economy is accelerating faster than previously estimated. The pound continued the climb it started after the BOE raised interest rates on August 3, 2006. The central bank now estimates annual economic growth will be slightly stronger, peaking at three percent in the second half of 2007, before slowing to 2.5% in 2008. This stronger growth will be accompanied by increasing inflation, making further rate increases by the BOE likely. With positive rate differentials and a growing economy, the pound sterling has move up to number two (just behind the Swedish krona) on the YTD best performing currencies versus the United States dollar.

A reader pointed out yesterday that I hadn’t been talking much about the Thai baht, which we had been suggesting as an excellent way to get yield in Asia. Well the Thai baht rose to its highest in almost three months yesterday, as the central-bank governor said the currency will extend gains that have made it Asia’s best performer this year. The baht “has to strengthen,” Bank of Thailand Chief Pridiyathorn Devakula said in an interview published today. As we have pointed out in the past, Asian central banks are notorious for intervening in the markets to keep their currencies down in order to help exporters.  Pridiyathorn said the central bank wouldn’t try to buck the trend of the currency’s appreciation. “If you go against the trend, you are dead,” he said. “I’m telling the exporters this so they can prepare themselves.” The Thai baht makes up 40% of our new Orient Opportunity Index CD, which will hopefully be one of the best performers of 2006. Now, if we could just get Pridiyathorn to convince his colleagues in Japan to stay away from manipulating the markets!

That leads me to the currency that has been trying our patience for the last few years, the Japanese yen. The yen halted a two-day slide against the dollar after an unexpected surge in Japanese machinery orders fueled speculation that the Bank of Japan may lift borrowing costs a second time this year. As readers will recall, the BOJ lifted its benchmark rate for the first time in six years on July 14,2006, but then came out with statements that made it look like there would be no more rate increases during the rest of 2006.

Since then, two different BOJ board members have come out to say there is still a possibility of further rate increases. No matter the timing, it is clear that the interest-rate differential that has held down the yen is narrowing. Hopefully the central bank will finally let the currency appreciate as the interest rates move up.

Currencies today: A$ .7649, kiwi .6296, C$ .8941, euro 1.2889, sterling 1.9087, Swiss .8180, ISK 71.0, rand 6.7362, krone 6.148, SEK 7.11, forint 209.08, zloty 3.00, koruna 21.80, yen 114.85, baht 37.57, sing 1.5723, INR 46.46, China 7.976, pesos 10.86, dollar index 84.45, silver $12.30, and gold $645.25

That’s it for today. Happy birthday to the newest addition to our trade desk, Kristin (yes we now have three variations of Chris on the desk). Christine just called with news that she is bringing in Starbucks. Hope everyone has a great Wired Wednesday!!!

Chris Gaffney
August 9, 2006