The Deficit Sets Another Record

Good day. The data didn’t disappoint us yesterday, as the current account deficits (CAD) came in larger than expected and advance retail sales came in below expectations. The dollar bulls lost their grip on the hammer, as the U.S. dollar fell against all major currencies. The yen had the largest move trading all the way back down to 117.50, but the Icelandic krona and Chinese renminbi also made some pretty dramatic moves. But first, back to the U.S. CAD announcement.

The U.S. current account deficit increased to $225 billion in the fourth quarter, from a revised $184 billion in the third quarter. This number was large enough to force the markets to take notice and the U.S. dollar was pushed down. While the current account deficit started the dollar down, the disappointing advance retail sales numbers and a rumor accelerated the dollars decline. Medley Global Advisors, a New York-based firm that provides research for hedge funds, said most Federal Reserve policy makers want the central bank to stop raising its main interest rate after one or two more quarter-point increases. This shifted the currency traders’ focus away from the interest-rate differential talk, which kept the U.S. dollar strong in 2005, and focused them back on the deficits. This will likely cause a sell off of the greenback in 2006.

Our corporate foreign exchange risk manager, Ashish Advani, e-mailed me a story from Reuters, which had some pretty good quotes from the new Fed Chairman Ben Bernanke. “I am quite concerned about the intermediate to long-term federal budget outlook,” Bernanke said in a letter to Sen. Robert Menendez, following up on the Fed chief’s February 16, 2006 testimony in the Senate Banking Committee.

“In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending. By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country,” Bernanke said. These are some pretty strong words from the Fed Chairman and definitely reflect his concern with the current path of the U.S. economy. Anyone who thought he was going to be in the deficits-really-don’t-matter camp should sit up and take notice.

Today, we will see if the amount of foreign investment in the United States is going to be enough to sustain these deficits. Net foreign security purchases will be released at 8:00 EST and will be the piece of data moving the markets. Economists predict the number will show an increase to 64.8 billion from 56.6 billion last month. We will also get the release of the Fed’s beige book today, which may give us an indication of just how many more interest rate increases we have in store.

A poll released yesterday by Merrill Lynch confirmed Chuck’s observations of last week that there has been a general “risk aversion” in the markets. The investment bank’s latest survey of 197 global fund managers showed a further loss of risk appetite in early March and curbed some of their fervor for emerging markets in the face of rising global interest rates. This move to safety has had a positive impact on the Swiss franc and euro and caused some of the sell-off in the high-rate currencies of Iceland, Mexico, Brazil, and New Zealand.

With interest rates expected to rise in both Switzerland and Japan, the carry trades in which investors borrow these low interest rate currencies to invest in the high interest rate emerging market currencies will continue to unwind. This will put additional pressure on the New Zealand dollar, which is one of the carry trader’s favorite investments. On the flip side, this unwinding will probably move both the Swiss franc and Japanese yen up in value. The Swiss franc will also benefit from a 0.25 or 0.50% increase, which expected to be announced tomorrow.

The Icelandic krona continued to claw its way back up, moving back below 70 this morning. As I wrote yesterday, we think the sell off has been overdone in this currency. I would look for a continued recovery over the next few days.

China’s Renminbi had the biggest gain since unpegging from the dollar after Premier Wen Jiabao said the market is going play a greater role in setting exchange rates. “We will further improve the renminbi exchange-rate mechanism, expand the foreign-exchange market and add more flexibility to the exchange rate’s trading band,” Wen said at the close of parliament’s annual meeting yesterday in Beijing. Pressure continues to mount on China to let its currency trade more freely before the U.S. Treasury’s semiannual report on currency manipulation scheduled for next month. Again, don’t expect any dramatic revaluations of the Chinese reniminbi, but we still feel the currency will continue its steady march up in value and should trade below eight by the end of summer.

Currencies today: A$ .7383, kiwi .6432, C$ .8657, euro 1.2029, sterling 1.7454, Swiss .7684, ISK 69.98, rand 6.2033, krone 6.6171, forint 218.30, zloty 3.2339, koruna 23.91, yen 117.56, baht 39.19, sing 1.6198, China 8.0377, pesos 10.651, dollar index 89.96, silver $10.26, and gold $551.62

That’s it for today. Congrats to our fearless leader, Chuck Butler, who was honored down in Florida, last night, for being one of EverBanks “All Stars.” It’s Wired Wednesday today. I can’t wait until Christine brings in the Lattes!! Have a great day.

Chris Gaffney
March 15, 2006