Another Slide in the Dollar

Good day…The dollar is confirming our sentiment, dropping again versus most of the major currencies. Yesterday’s confidence numbers came in well below expectations, even with the dramatic drop in gasoline prices during October. Maybe the U.S. consumer isn’t as clueless as I thought.

The downward trend that we saw the dollar take during April of this year, looks like it may be back. As you will remember, the U.S. dollar lost over 6% of its value versus most of the major currencies during the month of April. Since then the U.S. dollar has been range trading; but the data we have seen over the past few weeks gives me the feeling that another dramatic drop is beginning.

The data released today should confirm the weakness of the U.S. economy. Mortgage applications have already been released, and to no one’s surprise, they came in down 3%, well below last month’s small increase. Later this morning we will see the ISM Manufacturing index and prices paid, pending home sales, and vehicles sales data. I don’t believe any of this data will surprise on the upside, and will likely confirm that manufacturing in the United States is slowing along with housing.

On the flip side, we saw such an aggressive move down by the dollar yesterday – after the poor confidence data – that any sliver of hope in today’s numbers could be used to reverse some of yesterday’s slide. Again, I look for the numbers to show the U.S. economy continuing to slow, and the dollar should continue to sell off.

I mentioned Fed member Lacker yesterday and how he is insisting that the FOMC increase interest rates. Well…several traders are now increasing bets that the next move by the Federal Reserve will be to cut borrowing costs during the first quarter. With weak economic data and oil prices stabilized, the FOMC will likely just keep rates unchanged during the rest of this year. The chance of a Fed rate cut by the first quarter of next year is remote at best in my opinion, but I also don’t believe you will see an increase any time soon.

The dollar also lost ground yesterday on news of additional central bank diversification of their currency reserves. The United Arab Emirates is the world’s second largest Arab economy, and the governor of its central bank, Sultan Nasser al-Suwaidi, said on October 30 that it will cut the dollars it holds by almost half to reduce its dependence on the weakening U.S. currency.

Figures it released last week showed that the Swiss central bank raised its holdings of yen and pared investments in dollars last quarter.

And finally, Russia is considering lifting holdings of yen in coming months according to the central bank’s first deputy chairman. All of these ‘reallocations’ will only continue the downward spiral of the dollar, and could feed on each other creating an all out freefall as holders of the greenbacks rush toward the exits!

The euro will likely benefit today from speculations that European Central Bank President Jean-Claude Trichet will signal that policy makers are ready to increase rates in December. The central bank chief has used the word ‘vigilance’ in the past to signal imminent increases after the bank’s previous policy meetings. He dropped that word after the October fifth meeting, suggesting the bank will pause this month. If the accompanying report contains the word ‘vigilance,’ the traders will likely run the euro up versus the U.S. dollar on thoughts the ECB will raise rates again in December.

The pound sterling has been gaining versus the U.S. dollar and euro lately on speculation the BOE will lift borrowing costs twice more by the middle of 2007 in order to curb inflation. The U.K. housing market has rebounded nicely and is starting to gather momentum, making the BOE nervous about future inflationary pressures. Inflation surpassed the bank’s 2% target for a fifth month in September, mainly due to an increase in house prices.

Norway’s central bank raised its benchmark interest rate for the sixth time since June 2005, to keep inflation low in the face of labor shortages and soaring borrowing. The rate decision was announced today when policy makers updated forecasts for inflation and economic growth. The accompanying report suggested rates would be gradually raised to a more normal level at a somewhat faster pace than envisaged earlier. This rate increase should help reverse the sell off we saw in the Norwegian krone over the past three months.

The commodity currencies of the South African rand, Australian dollar, and New Zealand dollar continue to increase as commodities rally. The currency of South Africa rose by the most in three weeks yesterday, after a report showed the trade deficit shrunk to its lowest this year during September. The Australian dollar benefited from a dramatic increase in home-building approvals which rose three times as much as expected. Growing demand for housing has tempered the effect of rising interest rates, which will likely be raised next week for a third time this year. One commodity currency didn’t fare as well as the others, as the Canadian dollar dropped the most in three weeks after the government said it plans to increase taxes on foreign investors who own the country’s income trusts.

Ashish Advani, the Head of Corporate FX here at EverBank, pointed out yesterday that India had split their two interest rates yesterday. Here is what Ashish pointed out to us after the rate announcement:

The Reserve Bank of India (RBI) managed to completely surprise markets by raising the repurchase rate (the rate at which the market borrows from the RBI in a liquidity deficit situation) by 25 basis points to 7.25% while leaving the benchmark reverse repo rate unchanged. We were expecting a hike in both repo as well as reverse repo rate by 25 basis points each.

Why has the RBI done this?

Well…they’ve done this to balance out the risks of global deceleration with the risk of demand side inflationary pressures thawing domestic growth. With the global growth environment turning more uncertain, and the U.S. economy showing signs of deceleration, the risk remains that excessive monetary tightening domestically could impact domestic growth.

However, with domestic price pressures rising, the RBI cannot afford to sit on the sidelines and let inflation go beyond the tolerance band of 5-5.5 percent. The RBI clearly recognizes the risk that India could be entering the overheating zone, and asset price inflation too could hurt the real sector. Hence the RBI chooses to signal potential for higher rates by raising the repo rate; but should growth outlook reverse dramatically, the impact on domestic economy would be marginal. Also, another signal in our assessment is that, should banks face tight liquidity conditions, the overall borrowing costs increase, thus the cost of money goes up in a situation where banks over extend credit.

Thanks to Ashish for bringing us all up to date on this unusual move by the Indian Central bank. This partial increase in the interest rates has caused the Indian rupee to rally, increasing by almost 0.4% yesterday.

Currencies today: A$ .7748, kiwi .6718, C$ .8822, euro 1.2760, sterling 1.9087, Swiss .8035, ISK 67.89, rand 7.346, krone 6.5161, SEK 7.2145, forint 203.07, zloty 3.029, koruna 21.98, yen 116.94, baht 36.65, sing 1.5598, INR 44.86, China 7.8719, pesos 10.742, dollar index 85.39, Silver $12.33, and Gold… $610.40

That’s it for today… We had a beautiful night for Halloween, but didn’t have the normal groups of children at the door. Unfortunately, it may be a sign of the times that many children are no longer allowed to walk from house to house trick-or-treating. I guess you can’t argue that it is much safer taking them to the indoor candy swaps or ‘trick-or-trunk’ events held in church parking lots. But it sure is a sad sign of the times. Christine is bringing in the coffee this morning; hope everyone has a great Wired Wednesday!!!

Chuck Butler
November 1, 2006

The Daily Reckoning