Chris Gaffney

It was another “risk off” day yesterday as investors moved out of higher yielding currencies and back into the safe haven of Swiss francs (CHF), which was the best performer. The Japanese yen (JPY) also ticked up a bit versus the US dollar yesterday with the Australian (AUD) and New Zealand (NZD) dollars both dropping. The US dollar pushed higher throughout the trading day, but reversed course and began to drift lower in overnight trading. As I turn the trading screens back on this morning I see the dollar has given back most of its gains from yesterday, and is back around 73.

I enjoyed my time down in Panama last week, and got to address the crowds four times, with two general session talks and two workshops. The first of my general session presentations was titled “The coming regime change in currencies” and I shared my thoughts on the fragile status of the US dollar as the globe’s reserve currency. With all of the debt and deficits that we have accumulated, the reserve status of the US dollar is definitely in danger. One of the obvious alternatives is the Chinese renminbi (CNY). The Chinese economy continues to grow, and is now predicted to overtake the US and become the world’s largest economy within the next five years. The Chinese automobile market is now the largest, and their growing middle class now has as many members as the entire population of the US.

But in the short term I don’t see how the Chinese currency can replace the dollar as the reserve currency, as the Chinese financial system is still nascent. But as Chuck has mentioned several times, China is trying to gain a wider acceptance of the renminbi in international trade. They have arranged swap agreements with some of their largest trading partners, avoiding the use of US dollar. They have also begun to allow the trading of fixed income securities denominated in renminbi on the Hong Kong markets. These bonds are called “Dim Sum” and have been rallying dramatically as investors push their prices higher.

All of these efforts by the Chinese government to gain a wider acceptance of the renminbi seem to be paying off. A report released by HSBC overnight suggested that the renminbi would overtake the British pound (GBP) this year to become the world’s third most popular trade-settlement currency. HSBC conducted a survey of small and medium sized trading companies and more respondents chose the Chinese renminbi as their primary currency than selected the pound for the first time since the survey began. The US dollar and euro (EUR) are still the two top currencies used for international trade, but the Chinese currency is now number three. The emerging markets are driving much of the growth of the use of the renminbi, and with good growth expectations continuing in these markets, the acceptance of the Chinese renminbi will undoubtedly grow. The next step China needs to take is to ease back on their control of the renminbi. Again, I don’t think this is going to be a quick decision, but will take some time. China will continue their “slow and steady” release of the renminbi, but I do think that over time the renminbi will become free floating. Once this happens, the renminbi will be in a place to become the next global reserve currency.

Until then, I think we will see a growing dependence on Special Drawing Rights (SDRs) which were created by the IMF in 1969 during Bretton Woods. SDRs are currently a basket of four different currencies (USD, EUR, GBP and JPY) but the basket is re-evaluated every five years and the Chinese renminbi will undoubtedly be added eventually. I believe the SDRs are what will become the world’s next reserve currency, decreasing the importance of the US dollar on global trade. This is just another nail in the coffin of the US dollar, and we will continue to see its value slide in the coming years.

But enough with the lecturing, you all want to hear about today’s currency markets. The euro is moving a bit higher this morning as investors raise bets that the ECB will take a more hawkish tone in their rate statement. While Ben Bernanke has made it clear the US will keep rates near zero for the near future, the ECB will probably signal they are ready to begin raising rates in Europe. A report released this morning showed that the growth in European services and manufacturing accelerated in April, led by factory output. The index rose from 57.6 to 57.8, and any reading above 50 indicates expansion. Prices in Europe are also on the rise, with factory gate prices jumping 6.7% from a year earlier, the fastest pace since September of 2008. Inflation fears are expected to force the ECB to sound a hawkish tone after their meeting tomorrow. Higher interest rates will undoubtedly push the euro higher, in spite of the continuing sovereign debt crisis.

Speaking of the European sovereign debt crisis, Portugal agreed to a $116 billion bailout. The three-year plan sets goals for a budget deficit of 5.9% of GDP for 2011, and a reduction to 4.5% in 2012 and 3% in 2013. These deficits are slightly higher than previous targets, and is seen to be attainable. It looks like Portugal has dodged the bullet, and the focus of the “bond vigilantes” will now move on to the next European victim. Could it be Spain? Italy? Or will it be one of the big boys like France? We will have to wait and see, but I can pretty much assure you that the sovereign debt crisis is not over, and we will see another victim sometime in the near future (probably as the euro pushes past $1.50).

The commodities continue to slip with silver making the biggest move down nearly 14% in the past five days. The fall in silver was somewhat expected, as it had been moving much too fast in the other direction. And looking at the other precious metals, both gold and platinum are actually up slightly in the past five days. I still think commodities are in a long-term bull market, as the growth in the number of consumers in China and Asia will push demand higher.

But the recent fall has weighed on the commodity-driven currencies of Australia, New Zealand, and South Africa (ZAR). The Australian dollar was also pushed down by rising expectations that the RBA will extend its pause in raising rates after leaving them unchanged at their rate meeting. In spite of rising inflation pressures, the RBA said it feels inflation will remain near its target for the coming year. Traders lowered bets that the RBA will be moving interest rates higher after the AUD moved higher versus the US dollar. Governor Glenn Stevens is still sounding pretty hawkish though, and a move up by the RBA is still possible. The kiwi had the largest drop versus the US dollar after a government report showed private sector wages grew at a slower pace than some expected.

The Canadian dollar (CAD) didn’t participate in the slide of the commodity currencies, and actually moved a bit higher versus the US dollar. The election results, which gave Prime Minister Stephen Harper’s conservative party the first majority in seven years, were good news for the loonie. Harper has pledged to eliminate Canada’s budget deficit by 2014 and cut corporate taxes and spending, and his decisive win certainly looks like a stamp of approval for these policy choices. The election is being seen as a mandate for Harper to continue to cut government spending, and continued growth of the Canadian economy combined with a strengthening fiscal position should help bolster the Canadian dollar in the global markets.

India’s central bank raised benchmark interest rates by a more-than-estimated 50 basis points today. The central bank expects that inflation will remain at “elevated levels” until at least September. Inflation in India is the second highest among the BRIC nations (Russia’s is higher) led by food and energy price increases. The central bank hopes that the higher rates will slow the economy enough to bring inflation below their target of 6% within the year. The Indian rupee (INR) really hasn’t moved versus the US dollar this year, and if the central bank continues to increase interest rates it could be a good alternative for investors looking for Asian exposure with a decent interest rate. The Indian rupee CDs are currently the second highest paying after CDs in South African rand.

To recap… China is predicted to overtake the pound sterling and become the globe’s third most popular currency for trade (behind the US dollar and euro). The ECB is expected to push rates higher, and Portugal has agreed to a bailout. Commodities slipped, pulling the commodity currencies down with them. Harper’s big election victory helped push the loonie higher in spite of the commodity drop. And finally, India has raised their rates another 50 basis points and is now one of the highest yielders we offer.

Chris Gaffney
for The Daily Reckoning

Chris Gaffney

Chris Gaffney is vice president of EverBank World Markets and the alternate author of the popular Daily Pfenning newsletter. Mr. Gaffney has been involved in the global marketplace since 1987, and is director of sales for EverBank World Markets. The Daily Pfennig is delivered via e-mail to tens of thousands of market watchers globally, providing commentary that allows them to stay on top of economic, currency, and market happenings. He is a Chartered Financial Analyst and holds degrees in accounting and finance from Washington University in St. Louis.

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