The Dollar Swings Its Hammer Again!

Good day. Quite a boring day, currency movement wise, yesterday as the U.S. banks were on holiday, and once the London “Boys” went home, liquidity dried up like a worm trying to get across the concrete on a hot summer day! OK…maybe that was not a good way to describe it, especially since most of you have a cup of coffee as you are reading the Pfennig!

Since there wasn’t much movement yesterday, I’ll bring you up to date on what’s gone on overnight, and then hit on some dollar related items that really touch home with me that I never get to talk about in the Pfennig, due to time and space limitations. Hope your coffee cup is full, because today’s is going to be a long one!

First things first though…overnight the dollar has been swinging its hammer again, and the currencies are all lining up for their punishment. The euro has fallen below the 1.26 level to 1.2570, all on a turn around of thoughts by the markets. Last week, I told you that the markets were all thinking that the Fed was finished with rate hikes, and their next move would be a cut in 2007. At the time, I said that I didn’t disagree with the rate cut in 2007, but said there would be at least one more rate hike before we got to the end of the rate hike cycle.

Well…either there are a ton of Pfennig readers that saw the light…or the Bureau of Labor Statistics’ announcement that they would add 810k to the jobs created side of the ledger next spring. That has caused the currency market participants to go back and re-think their positioning. No currency has gone unscathed, although the Asian currencies of Thailand and Singapore have held onto their levels, and the New Zealand dollar bucks the trading direction overnight. Kiwi was able to move higher vs. the dollar after a business opinion report showed a significant drop from 40% to 26% in the seasonally adjusted net balance of firms expecting the general business situation to deteriorate in the next six months. This could alert the Reserve Bank to remain on rate hike alert.

I know a lot of readers also read my friend, John Mauldin and his weekly “Out of the Box” letter that distributes another writer’s views. So before everyone begins to send me his letter, and tell me to read it because the writer, Lacy Hunt of Van Hoisington writes that the deficits won’t have anything to do with the value of the dollar…I beg to differ!

I always tell my audiences that they need to look at a currency as the “stock” of that country. And when you go about picking a stock, you look at the balance sheet, among other things, before buying. Well… If you look at the U.S. dollar as the “stock” of the United States, the dollar’s value has corresponded directly to the level of the Current Account… Is the dollar not down VS the euro since 2002 by almost 50%? And what has the Current Account done since that time?

OK… Now a special treat this morning… As many long time readers know… I’m a huge fan of economist Stephen Roach of Morgan Stanley. I have to say that Mr. Roach and I haven’t been agreeing with a lot of what he has to say… But recently, he wrote a piece about Germany and Japan, that will be the “guest writer feature” in the next Review & Focus (that’s available to clients of EverBank World Markets)… And then yesterday he had this to say… Again, this is Stephen Roach of Morgan Stanley…

“The greatest risk, in my view, is that we have focused too much on the visible manifestation of excess liquidity and not enough on the second-order effects.  Here, I am referring to the American consumer’s shift from income- to asset-based saving — and the resulting depletion of national saving that has given rise to massive US current account and trade deficits.  In a climate of persistently sub par job growth and near stagnation in real wages, these external imbalances have also sparked worrisome political tensions — namely, a Washington-led outbreak of China bashing.  The excesses of the global liquidity cycle are not just about surging demand for financial assets and/or the risks of inflation.  They lie at the heart of a much broader set of tensions that are bearing down on the world economy.  The good news is that the stewards of globalization –namely the IMF and G-7 finance ministers — are now mindful of these risks.  The bad news is that they don’t have any power over the monetary and fiscal authorities who can actually make things happen.

All this underscores the perils of an exquisite moral hazard dilemma.  Central banks have created a monster — not just liquidity-driven excesses in financial markets but also major cross-border imbalances in the global economy and mounting political tensions associated with those imbalances.  Nor do I believe that the instability of this disequilibrium can be resolved through a mere normalization of monetary policies.  Ultimately, a more meaningful shift to policy restraint will probably be required.  At the same time, by waiting this long to face up to the excesses of the global liquidity cycle, the systemic risks embedded in world financial markets and the global economy have only gotten worse.  A monetary tightening that goes too far risks a collapse in this proverbial house of cards.  Yes, the world economy has been very resilient over the past five years — but at a real cost.  Increasingly, the celebrants of global resilience are dancing on the head of a pin.”

Back to Chuck… I have to say that this creation of dollar supply has really gone too far… And too much of something eventually loses its value, doesn’t it? Of course it does… Shoot, even the Chinese know that they have too many dollars… Remember last week when I told you that China would probably reach the $1 Trillion level of dollar reserves before the end of the year?

Well… Fan Gang, a member of the People’s Bank of China had something to say about this $1 Trillion in dollar reserves… Fan Gang was speaking at a seminar last night and has this to say… “the dollar may extend its losses as there is too much supply of the currency in foreign exchange markets.”

OK… Also last week I asked about where all the volatility in the currencies has gone? We just haven’t seen volatility in a month of Sundays… Let’s just take a look at the items that are going on right now… In the past month we’ve seen a military coup in Thailand, a hedge fund liquidate after losing $6 Billion, a nuclear test by the North Korean government, and OPEC announce oil production cuts, and all were shrugged off by the FX market.

In addition, the Mogambo Guru pointed out something that plays well with this list of items that have failed to light a fire under the currencies… This is from his letter of yesterday… “Michael A. Nystrom, in his essay at titled “Dow Manipulation” seems to agree with me. He notes that the litany of bad news is overwhelming when he lists, “The yield curve has remained inverted for months; we had the first negative reading in the Philly Fed index in three years; national housing sales have plunged and prices are showing their first declines since 1993. The index of leading economic indicators has declined for seven straight months. Online advertising revenue is down; newspaper advertising revenue is down; the help wanted index is down.

Across the board the economic news is terrible – everything is pointing to a recession.”

But dollars are still being bought? Just makes me believe that like everything else that we experience… The longer something is allowed to go on, the harder the fall, the rougher the road, the more painful the tooth… And the larger the losses…

Currencies today: A$ .7445, kiwi .6610, C$ .8870, euro 1.2560, sterling 1.8595, Swiss .7890, ISK 68.93, rand 7.7980, krone 6.6560, SEK 7.3850, forint 215.55, zloty 3.1145, koruna 22.4375, yen 119.50, baht 37.50, sing 1.5890, HKD 7.7934, INR 45.80, China 7.91, pesos 11.07, dollar index 86.81, Silver 11.35, and Gold… $576

That’s it for today… Everyone returns today, so I’ve got that going for me! I’ll be out all next week, first at the San Francisco Money Show, and then onto Panama for the International Living Ultimate Event. I’ll write Monday – Wednesday, and Chris will have the Conn on Thursday, Friday, and the following Monday… Hopefully by then, my beloved Cardinals will be in the World Series! Have a great Tuesday!

Chuck Butler
October 10, 2006