Soft Landing Ahead

Good day… The dollar rallied slightly overnight as traders booked gains going into the long Christmas holiday. After yesterday’s lack of data releases in the United States, today we will see a number of different reports that could move the markets. Any movements may be exaggerated because of the light coverage on the currency desks.

U.S. GDP will lead us off this morning, with economists predicting no change in the Commerce Department’s final estimate. The U.S. economy grew by just 2.2% in the third quarter, the slowest pace of this year. Growth would have been even slower except for a buildup in inventories, which is not a good omen for fourth quarter GDP. We will also see personal consumption and the Core PCE quarterly figure, which is one of the fed’s favorite inflation indicators. Core PCE is expected to be flat for the quarter, which will encourage the FOMC to keep rates right where they are.

Finally we will see the weekly jobs data followed by leading indicators and the Philly Fed index. All of this data is expected to show slight weakness in the economy, with leading indicators coming in at just 0.1% after an increase of 0.2% last month.

Right now it looks like the boys at the fed are convinced we are heading for a “soft” landing in the United States. The wildcard in all of this continues to be the Asian central banks, which hold a large amount of U.S. debt. If they continue to slowly exit the U.S. dollar, and allow their home currencies to appreciate, the ‘soft landing’ will materialize. But if one of them blinks and starts to accelerate their sales, interest rates will be forced up in the United States, right when it looks like the economy is slowing. Not a good combination. Throw in another spike in oil prices and you could see the downward spiral snowball into a full-blown recession here in the United States.

European Central Bank President Trichet had a birthday yesterday and was feeling pretty good about his leadership of the European economies. In an interview yesterday, Trichet had a message for his critics who have complained about interest rate increases by the ECB, “What we did a year ago and since then has been fully vindicated. Our message is very, very clear: We will do whatever is necessary to ensure price stability.” Europe is now growing the fastest in six years and the ECB, living up to their hawkish tradition, will likely continue to raise rates in 2007. Good things ahead for the euro!!

It looks like the BOJ could learn a thing or two from the ECB. Japan’s export growth unexpectedly accelerated in November. Exports grew mainly due to the sustained weakness in the yen. The BOJ now finds itself in a very precarious position. Because they have maintained their low interest rate policy for so long, investors have borrowed yen in record amounts, placing a “short” on the currency. As Chuck has explained in the past, this borrowing of yen is one step in what is commonly called the carry trade.

The danger the BOJ risks, is that any increase in interest rates will prompt the reversal of these trades. Reversing these carry trades will force the value of the yen upward, and with the sheer size of these trades, the move could be dramatic. Tomorrow we will get the release of minutes for the BOJ’s meeting last month. If these minutes show that officials plan on delaying further increases in rates, you will likely see the yen hold on to its current weakness; but if they suggest a move up at the next meeting, the yen will likely strengthen. Again, with the current market conditions, I don’t think it is a question of if the yen will strengthen, but rather when and by how much.

Iceland raised rates overnight, surprising the markets in what was largely seen as an attempt to reduce a burgeoning current account deficit. Investment in aluminum smelters has sucked in imports, pushing the current account deficit to 27% of GDP. While this deficit is very large, the aluminum smelters are just now coming online so GDP should see an increase. With a small overall economy, this increase in GDP will have a much faster impact on the current account deficits. The risks are that these higher interest rates cause a hard landing and recession in Iceland. The krona remains for speculators only.

The Indian rupee rose to the highest in almost a month as local lenders said they’d bring money home by raising loans overseas. A faster pace of growth in Asia’s fourth largest economy, which averaged 9.1%in the first three quarters of the year compared with last year’s 8.25%, is fueling the rupee. We continue to offer Indian rupee CDs with a minimum investment of $20,000 and interest rates around 3%.

The Thai baht dropped slightly overnight as international investors continued to sell holdings in the stock and bond markets. The Bank of Thailand Governor was busy defending the measures instituted at the beginning of the week even after having to partially rescind them. The governor suggested that the rules would be lifted once the currency stabilizes. “As soon as the volatility reduces, we will lift the requirement,” Governor Tarisa said in an interview today. “This is temporary.” We are still unable to sell forward, so CD holders will need to sit tight and wait to sell at maturity. Even if/when the restrictions are lifted, I wouldn’t expect the forward markets to return to their previous liquidity. The damage has been done and I wouldn’t look for us to be able to offer the currency anytime in the near future.

Currencies today: A$ .7851, kiwi .6954, C$ .8694, euro 1.3181, sterling 1.9628, Swiss .8217, ISK 69.56, rand 7.00, krone 6.1859, SEK 6.8113, forint 191.82, zloty 2.8887, koruna 20.89, yen 118.22, baht 36.46, sing 1.5410, HKD 7.7748, INR 44.61, China 7.8180, pesos 10.8328, dollar index 83.51, Silver $12.50, and Gold… $621.70

That’s it for today…Today is the big shopping trip for Chuck and his buddies. Every year he meets with a group of friends and they spend the entire day trying to cause a rise in St. Louis retail sales. Unfortunately it is raining today, which may reduce the number of stops on this year’s annual shopping trip. The currency markets could be volatile, as many traders have already started taking off for the holidays. Hope everyone has a great Thursday!!

Chris Gaffney
December 21, 2006