Smoke and mirrors

Good day. The dollar declined against the euro and the yen yesterday, after a U.S. Treasury Department report showed foreign purchases of U.S. securities were less than the amount needed to finance the trade deficit for a second straight month. If international investors are no longer investing enough to finance the trade deficit, just how is the dollar keeping as strong as it is? Smoke and mirrors. It sounds like the U.S. government may be taking a page out of the Enron guide to economic management.

As Chuck has explained numerous times over the past years, the trade deficit and net foreign purchases are two of the most important fundamental factors affecting the value of the U.S. dollar. The trade deficit, a monthly figure, grew to a record $68.5 billion in January, from 65.1 billion a month earlier. To compensate for the gap in the current account and maintain the value of the dollar, the United States has to attract from overseas just under three billion dollars a day, or about 85 billion dollars a month. If and when international investors can’t or won’t finance this gap, the value of the U.S. dollar must fall. The currency markets may push these fundamentals to the side and react to interest rate differentials in the short term, but eventually the value of the U.S. dollar will be determined by these structural factors, which currently predict a sharp fall in the U.S. dollar.

You can believe that even though Chuck was down in Florida, he was analyzing these reports to see just how they would impact the greenback. Here are some of his thoughts:

“The flows into the United States are interesting, because for the first time in over a year, equity purchases increased to a significant level! You just have to ask yourself, how many times do these foreign investors have to get burned by this scandal or the next scandal before they say, ‘never again!’ I think their foray into the equities will meet the same fate as previous ones. Once again, the Foreign Central Banks will be left to finance what now has become $3 billion dollars ‘a day'”

The dollar extended losses in afternoon trading after the Federal Reserve released its “beige book” report, which showed the economy was growing at a moderate pace. This weakened the argument for additional interest rate increases past the one or two additional rate increases that have already been priced in. This data just confirms that any rate increase after March 28, 2006, is becoming even more questionable. With the Fed nearing the end of their rate cycle, expected rate increases by the European Central Bank and the Bank of Japan will likely put more downward pressure on the greenback.

Chuck e-mailed me the following on this topic: “In my opinion…the ECB still is in what I would call a ‘sweet spot’ regarding rate hikes, while the Fed is hitting mulligans! Sooner or later, the ‘marshall’ is going to stop the Fed, and make them accept their last shot!”

Overnight, the euro and pound sterling continued to rise after U.K. sales recovered from last month’s sharp drop off to register a gain of 0.5% for the month of February. A U.K. housing survey also surprised the market on the upside. The pound has been sold off over the last few months on speculation that the BOE would be cutting rates. Both reports suggest a modest recovery in the U.K. economy that should keep the BOE from any rate cuts.

Canada’s dollar rose yesterday for a third straight day against the United States, as gold prices climbed. Gold and the Canadian dollar have moved in the same direction 87 percent of the time in the past year, but the loonie reversed yesterday’s gains this morning, after the release of Canadian CPI figures. Consumer prices in Canada rose less than forecasted in February from a year earlier and unexpectedly declined from January on lower energy prices. These figures suggest the Bank of Canada is closer to its goal of slowing the economy, and that further interest rate increases are in question.

On to the big finish:

Currencies today: A$ .7361, kiwi .6384, C$ .8629, euro 1.2070, sterling 1.7462, Swiss .7708, ISK 69.75, rand 6.2252, krone 6.5948, forint 216.02, zloty 3.2184, koruna 23.78, yen 117.62, baht 39.10, sing 1.6194, China 8.0390, pesos 10.651, dollar index 89.77, silver $10.28, and gold… $553.21

That’s it for today. We get the CPI data out this morning. If Canada’s numbers are any indication, we should see a number lower than expected and more downward pressure on the dollar. We also get the housing starts and jobless claims, so it should be a fun day in the currency markets! Hope everyone has a great Thursday. 

Chris Gaffney
March 16, 2006