US Dollar Declines But Stays in a Tight Range

The dollar slipped a bit against most of the major currencies yesterday, but moved back up overnight and most currencies are right where they were when I hit the send button yesterday. Both the Japanese yen (JPY) and Swiss franc (CHF) traded lower yesterday as gains in the equity markets and commodities gave investors a bit more confidence in the global recovery. The euro (EUR) rose yesterday, but traded back off in early European trading as German Chancellor Angela Merkel suggested she may make it difficult for Greece to get more help. The bounce in commodities helped push both the Canadian (CAD) and Australian dollars (AUD) up a bit, and the British pound (GBP) rallied after inflation expectations were increased.

There was a bit of data released yesterday in the US markets, with reports showing that both import prices and wholesale inventories rose more than expected. Wholesale inventories increased 1.1% during March, as manufacturers stocked up on goods in the face of rising commodity prices. The bigger surprise was in the Import Price Index which showed that the price of goods being shipped into the US rose a staggering 11.1% YOY. This follows an adjusted 9.9% increase in March, so there is a definite pattern here. While the ‘official’ price gauge used by Bernanke and his boys doesn’t indicate any inflationary pressures, everything else sure makes it apparent that inflation is indeed climbing.

Today we will get an indication of the US trade deficit which probably widened a bit in March as a result of the higher import prices reported yesterday. The gap is expected to have grown to $47 billion in March from $45.8 billion the previous month. The drop in the value of the US dollar has an immediate negative impact on the trade gap as imports are more expensive in US dollar terms. But at the same time, the lower US dollar should help boost exports as goods and services can be priced more competitively in the foreign markets. Our biggest trade gap is again with China, which shouldn’t surprise anyone.

China and the US provided numerous sound bytes for the cable news stations over the past couple of days. It all played out pretty much as scripted, with US Treasury Secretary Timothy Geithner calling for faster appreciation of the renminbi (CNY) and a more open financial system for China while the Chinese said they would work toward a more flexible currency and will guide monetary policy to help calm price increases. As I reported Monday, China has allowed the renminbi to appreciate to a record level versus the US dollar and the timing of this move higher is not coincidental. Chinese leaders know the best way to quiet US lawmakers’ calls for tariffs is to allow the currency to adjust higher, and the timing of the move aligns with their attempts to slow their economy and get control of rising prices.

Consumer prices in China rose 5.3% in April from a year earlier, following a 5.4% gain in the previous month. The price rises exceeded Premier Wen Jiabao’s 4% target and has caused many to speculate that the value of the renminbi will be allowed to rise further. Forward points in China jumped up, signaling that traders believe both interest rates and the value of the currency will be pushed higher by Chinese officials.

As I mentioned yesterday, China announced a record trade surplus last month, but they actually have a huge deficit on the services side. The US service surplus with China has accelerated rapidly as American companies continue to increase exports of insurance, banking, health, and education services. This is one area where China has really opened their markets up, and the US is benefiting from the growth of the Chinese middle class.

Last week I shared my views on how China will eventually become the world’s reserve currency, but first the markets will shift toward using the SDRs created by the IMF. Yesterday I noticed a story that didn’t appear on any of the cable news stations we have up on the TVs surrounding our trading desk. Kazakhstan’s central bank announced it would add the Chinese currency to its international reserves. The former Soviet Union’s second-biggest energy producer said it would allocate part of its holdings in the renminbi. The head of Kazakhstan’s central bank said that the renminbi is becoming more convertible, and is emerging as the global reserve currency, so they would be adding it to their reserves, diversifying out of the US dollar. Now I know Kazakhstan’s decision will have almost no impact on the global currency markets, but it is just one more sign that the Chinese currency is moving toward a more global acceptance, and will eventually challenge the US dollar for reserve status.

As I mentioned in the opening section, the pound sterling rallied overnight on expectations that the BOE would be raising rates soon as inflation heats up. BOE Governor Mervyn King said inflation remains ‘uncomfortably high’ and officials have signaled that they may need to raise interest rates later this year. “The recent pattern of revisions to the projections over the next year – downward to growth and upward to inflation – has continued,” King told reporters in London. Inflation has remained above the BOE’s 2% target and they expect it to push as high as 5% in the coming months. The BOE released their economic forecasts yesterday, which showed that a quarter-point interest rate increase by the end of the year would probably be needed to control inflation.

Inflation in Germany, Europe’s largest economy, is also accelerating faster than originally projected. The inflation rate jumped to 2.7% in April from 2.3% in March. Higher oil prices are being blamed for the increase in the inflation numbers (no, the Europeans don’t ignore food and energy in their inflation measures). The ECB has the same 2% target as the BOE, so these higher prices will probably lead to further rate increases following last month’s rate rise. With the US FOMC keeping rates on hold, higher rates in Europe should keep the euro from falling further in spite of all of the remaining concerns regarding the Euro-sovereign debt crisis.

Commodities rallied again yesterday, but are down a touch in early trading today. Silver climbed all the way back to just under $40 but is back down to $38 this morning. Gold is holding firm above $1,500 and continues to be less volatile than silver. The return of positive moves by the commodities has helped push both the Aussie and Canadian dollars higher.

To recap: The US dollar stayed in a fairly tight trading range this morning as US data showed a cloudy picture for the US recovery. China and the US continue to talk, following the same script they have used for the past few years. Pound sterling rallied on inflation expectations, and European inflation was also higher.

Chris Gaffney
for The Daily Reckoning