Back to Interest Rate Expectations

Good day… The dollar benefited from positive payroll data on Friday, only to lose ground later in the day. We have a fairly light week of data here in the United States, so I would expect the markets to be fairly stable. The markets continue to be in a “vacation” mode as trading is light and volatility will be somewhat subdued. We will get interest rate decisions from both Canada and China this week so these currencies could see additional strength as both may announce rate increases. And officials from the 13 nations that share the euro (EUR) will be meeting in Brussels today, so we should be prepared for the obligatory “sound bites” that sometimes move the markets.

On Friday, the jobs data in the United States showed that employers added 132,000 workers last month and wages grew. This fits nicely with the Federal Reserve’s prediction of a strengthening economy. The increase in employment followed a 190,000 gain in May that was larger than previously reported. The unemployment rate held steady at 4.5%, close to a six-year low. The dollar had gained versus most of the currencies prior to this report, and held its gains after the numbers were announced. But later in the day the dollar traded back off as interest rate expectations pushed money away from the dollar and back into the currencies where rates are expected to increase.

As I reported last week, interest rate differentials have returned to be the top story in the currency markets. I guess you can’t blame investors for moving toward currencies whose economies are so good the central banks have to raise rates to cool them off. The key factor to consider is why these central banks are raising rates. If prudent central banks are raising rates to keep inflation away from their economies, rate increases will benefit the currencies. But if the central banks are playing “catch up” and their actions are being forced by high inflation; rate increases will not ultimately benefit their countries.

The Canadian economy would be in the former group. The Bank of Canada will likely increase interest rates this week as strength in their economy is threatening to increase inflation. The Canadian dollar (CAD) climbed to the highest in 30 years on Friday after a government report showed employers added twice the expected number of jobs in June. With oil higher and employment strong, the loonie will likely continue its excellent run. Rates will be raised another 0.25% by the Bank of Canada this week, and the Canadian dollar looks to be heading toward parity with the U.S. dollar.

The U.K. economic growth accelerated in the second quarter, as GDP rose 0.7% after expanding 0.6% in the quarter ending in March. The government also reported that factory production rose in May to the highest in almost six years, a sign that rates aren’t too high to support economic expansion. As I reported last week, the BOE raised rates for a fifth time in 12 months, to a six-year high and signaled further increases may be needed. The BOE said inflation risks in the medium term “lie to the upside.”

Manufacturing orders in Germany increased more than forecast in May, led by foreign demand for investment and consumer goods. From May 2006, orders rose 7.5%. German companies have stepped up spending and hiring to meet booming export orders, creating new jobs and fueling the fastest period of economic growth since the turn of the century. The ECB has signaled that it’s preparing to raise interest rates for the ninth time since late 2005 to keep prices in check. Both the euro and pound sterling (GBP) will continue to benefit from interest rate expectations.

I read a quote from Nick Bennenbroek, head of currency research in New York at Wells Fargo & Co. this weekend which summed up the current attitude of currency traders: “Even if the U.S. economy’s going to be OK, it comes back to the interest rates, and on that score, the European Central Bank and Bank of England have been increasing rates. Those currencies are likely to do better.”

The “carry trade” looks like it is alive and well, as the Japanese yen (JPY) continues to be sold versus the higher yielding currencies. But professional traders aren’t the only ones selling yen. Tokyo mom and pop investors have now exceeded professional traders’ bets against the currency on the Chicago Mercantile Exchange. Retail investors are piling up yen short positions, which highlight the popularity of currency investment among Japanese individuals. As is the case with most investment vehicles, retail is typically the last to invest into the latest “fad”. Could this sudden rush by Japanese households be the beginning of the end for this carry trade? We will have to wait and see.

Gold has started to move back up and will likely rise for a second straight week as the rally in crude oil prices has boosted demand as an inflation hedge. Investors still use gold to preserve purchasing power in times of accelerating inflation. Silver has also gained on increased demand due to both global inflation pressures and industrial demand. We should have an announcement on our newest way to invest in Silver later this week.

Currencies today: A$ .8607, kiwi .7821, C$ .9560, euro 1.3630, sterling 2.0143, Swiss .8225, ISK 60.89, rand 6.9717, krone 5.8033, SEK 6.7284, forint 180.30, zloty 2.7533, koruna 21.041, yen 123.41, sing 1.519, HKD 7.8172, INR 40.415, China 7.6070, pesos 10.7547, dollar index 81.404, Silver $12.74, and Gold… $656.83

That’s it for today… It was a pretty weekend here in St. Louis but temperatures continued to be hotter than normal. I didn’t get a chance to run by Chuck’s this weekend, but will hopefully see him tonight, so I will give everyone and update tomorrow. The Cards will be represented by Albert Pujols and our manager this week, I only hope Albert doesn’t get hurt at the home run derby tonight (that’s it, I just jinxed him). Hope everyone has a great start to their week. Happy Monday!!

Chuck Butler — July 09, 2007

The Daily Reckoning