Assault on the U.S. Dollar

Good day. The currencies have continued their assault on the U.S. dollar overnight after trading in a tight range yesterday. The GDP data came in just a little under expectations, and personal consumption came in slightly higher. With these two releases offsetting each other, the currency markets turned to today’s releases of personal income and spending, the important PCE numbers, and weekly jobs data.

The income and spending data is expected to show U.S. consumers have returned to their old habits of increasing spending more than income. We pointed to last month’s figures, which showed larger increases in incomes than spending as a possible sign that U.S. consumers were finally tightening their wallets, but this months data will probably show this was just wishful thinking.

Bernanke’s Fed has put a priority on the PCE numbers as their preferred gauge of inflation. An increase in this data due out today will certainly bring the inflation hawks back to the forefront. Richmond Fed President Lacker, the sole dissenting vote in last month’s FOMC meeting, continues to preach for higher rates. He has been arguing for policy makers to set an inflation target of 1.5% He said, “until they decide to do so, I think the best approach we have is, to use one of my predecessor’s phrases, to err on the side of tightness.” He has stated that he will continue to push for higher rates, so any data that would give credence to his views will worry the markets.

The ECB left rates unchanged today after four increases in eight months. This was largely expected, and markets are now calling for two more 0.25% raises by year’s end.  President Jean-Claude Trichet will likely hint today that the ECB will increase rates at the next meeting on October 5, 2006. The Euro region’s economy expanded the most in six years in the second quarter from the first, outpacing the United States and Japan. We therefore expect another rate hike in October and December. These expected rate hikes will continue to support the euro and other European area currencies. Our new EuroTrax Index CD is a great way to take advantage of these currencies.

The Japanese yen just hasn’t participated in the most recent rally versus the U.S. dollar, mainly due to the return of the carry trade. Data released last night won’t help the yen, as industrial production unexpectedly fell in July. Factory output slipped a seasonally adjusted 0.9% from a record a month earlier. However, production actually gained 5.1% from a year earlier showing the Japanese economy is still moving in the right direction. Investors selling the yen for the carry trade breathed a little easier, as this data supports leaving interest rates in Japan unchanged. Investors in the yen need patience, the currency is undervalued, and will reverse quickly on any sign of an increase in Japanese interest rates.

The best performing currencies lately have been our old favorites that make up the Commodity Index CD. We have been singing the praises of the Australian dollar continuously, but just recently started to look again at the New Zealand dollar. The kiwi traded back above 0.65 overnight on speculation accelerating inflation will deter the central bank from cutting interest rates from a record high until next year. The New Zealand dollar was the world’s best performer this month, gaining five percent. It had its best month against the Aussie dollar in 17 years.

The worst performing currency of the Commodity Index CD has been the South African Rand. This currency is closely linked to the price of gold, trading off since the peak in mid-May. But the Rand headed for a third day of gains amid speculation a report will show inflation stayed near a three-year high last month, stoking speculation the central bank will lift interest rates. We wouldn’t suggest an investment directly in the Rand, but do think holding it as part of the Commodity Index CD is your best option. The Commodity Index has consistently been one of our best performers, and has a nice interest rate of 5.09% APY for three months.

Currencies today: A$ .7641, kiwi .6517, C$ .9031, euro 1.2860, sterling 1.9078, Swiss .8166, ISK 68.96, rand 7.07, krone 6.2879, SEK 7.2105, forint 213.71, zloty 3.0631, koruna 21.94, yen 117.15, baht 37.54, sing 1.5723, INR 46.54, China 7.9527, pesos 10.87, dollar index 84.83, silver $12.60, and gold $623.10.

That’s it for me this week. Chuck will be back from VT tomorrow. Lots of data out today and tomorrow. With most of the traders heading out early for the holiday weekend, we could see some volatility. Hope everyone has a great Thursday!!’

Chris Gaffney
August 31, 2006

The Daily Reckoning