Bernanke Hints at a Pause

Good day. The dollar fell dramatically yesterday, after Fed Chairman Bernanke said the FOMC could pause even if inflation risks remain. In keeping with the recent trend, the markets largely ignored the positive weekly employment data and instead waited to hear what Bernanke would say in his testimony to the Congressional Joint Economic Committee. Dollar bears were happy to hear him say that a pause is eminent.

Here is a quote from his testimony: “The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee’s judgment the risks to its objectives are not entirely balanced, at some point in the near future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook.”

While I was dead wrong about Bernanke’s testimony moving the markets, I was right on his new approach. He is clearly going to rely on the Fed’s forecast of an upcoming slowdown in the U.S. economy and therefore, will risk higher inflation in order to keep growth moving up. While the recent data doesn’t support pausing rates now, the FOMC clearly believes the economy is going to slow later this year and wants to keep from hiking rates up too high.

If the Fed is wrong on their forecast, we could see an acceleration of inflation, as firms pass on rising energy costs to customers. This will erode any credibility this new Fed chief has, as the number one goal of the FOMC is price stability.

“That’s his risk right now,” said William Ford, former president of the Atlanta Fed. “You can go back to the 1970s, when Fed chairmen really blew it when we had the last energy crisis by pumping in money and letting inflation get out of hand. He has to be very careful not to do that, or create the image of somebody doing that.” Remember the image of money being thrown out of helicopters? Bernanke looks like he is playing with fire in not making sure inflation remains tame!

While I question the Fed’s forecast on inflation, I like Bernanke’s focus on our current account deficit. Bernanke said the “large and widening deficit in the U.S. current account is another important challenge.” It sounds like Ben is a pfennig reader! “As foreign holdings of US assets increase, at some point foreigners may become less willing to add these assets to their portfolios. While it is likely that current account imbalances will be resolved gradually over time, there is small risk of a sudden shift in sentiment that could lead to disruptive changes in the value of the dollar and in other asset prices,” he said. Now where have I heard that before? Let me think. Oh yeah, that is almost word for word what Chuck has been saying for the past few years!!

Needless to say, Bernanke’s testimony was seen as bearish for the dollar by just about everyone listening in. Ashish Advani, our Corporate FX risk advisor sent me an e-mail he received from Goldman Sachs. It advised clients to continue selling dollars versus euros and yen. Lehman Brothers sent out a report saying the dollar is poised to extend losses against the euro and yen after breaching key levels. Lehman also advised their clients to continue to buy currencies of all countries with current account surpluses – including Switzerland, Sweden, and Norway.

Chuck wrote about this a few weeks ago, and again in May’s Review and Focus, which most of you will be receiving next week. In addition to the currencies Lehman mentioned, we also like all of the Asian currencies, which have good current account surpluses (with the exception of Thailand, which just went negative). The Eurozone and Canada are two others that meet the current account surplus criteria and would be good “core currencies” to own in all portfolios.

The U.S. current account deficits and a need for a weaker dollar were the subjects of an article in yesterday’s Wall Street Journal written by Harvard University Economics Professor Martin Feldstein. He states a lower dollar overseas, might raise sales volumes in exports from $892 billion in goods exported in 2005. It would also make products of low-wage manufacturers in Asia and Latin America less attractive to American consumers while boosting interest in domestically made goods. A similar monetary policy helped turn around the trade deficit in the 1980s, Feldstein noted. By 1989, the dollar had fallen 37 percent while inflation averaged about 3.1 percent. A few of his words are worth repeating: the dollar had fallen by 37 percent!!

Today, we will get the first quarter GDP figures, personal consumption, employment cost index, University of Michigan confidence, and the Chicago purchasing manager numbers. The big boy of these numbers, the GDP, is expected to be up big at 4.9%. Without Bernanke’s testimony yesterday, a strong GDP number would probably have rallied the U.S. dollar on interest rate expectations, but Ben seems to have taken the sting out of today’s numbers, as the markets now feel the FOMC will pause regardless of the data. As Chuck and I said yesterday, the currency markets are now bearish versus the U.S. dollar, so look for any positive U.S. numbers to be overlooked.

The Canadian dollar continued to rise. It reached a 14-year high for a second day after Bank of Canada signaled additional interest rate increases in its quarterly monetary policy report. “The Canadian economy is operating slightly above its capacity through 2006 and to return to capacity by the end of 2008,” the central bank said today in its monetary policy report. “Some modest further increase in the policy interest rate my be required.” Commodity exports continue to support the loonie. Future moves in the Canadian currency and exports depend on how global demand shifts to narrow the U.S. current account deficit. Other currencies, most likely, will appreciate faster against the U.S. dollar, the report said.

The Japanese may revert back to their old tricks of currency manipulation if the yen continues the pace of its recent slide. A ministry of finance official stated, “Japan will hold to its policy of standing ready to buy or sell the yen to curb ‘excessive’ fluctuations even after the Group of Seven urged faster gains in Asian currencies.”

“Speed matters,” the ministry official stated. “Excessive fluctuations in exchange rates are a problem.” This continues to be a problem with investments in the yen. The Japanese do not want the yen appreciating too quickly, and they have the currency reserves to back up their jawboning.

It seems they even got Fed Reserve Chairman Bernanke to join in. Both he and Hiroshi Watanabe, Japan’s vice finance minister for international affairs, both said investors misread the G-7 statement, if they believed it called for the dollar’s decline. These statements did stop the rapid rise of the yen, and the dollar actually rebounded for a short time. While the G-7 probably didn’t want such a rapid move of the currencies, there is little doubt they are calling for a lower U.S. dollar. Allowing currencies in Asia and in oil exporting countries to appreciate would help narrow global economic imbalances such as the U.S. trade deficit, the G-7 said.

Unfortunately the Icelandic Krona was unable to continue its slow climb back out of the hole it has fallen into. Prime Minister Halldor Asgrimsson again stated that Iceland may seek to join the European Union’s common currency, which halted the positive moves the currency had made.

Asgrimsson stated that joining the Euro is something they are considering in order to limit the currency speculation that has been occurring this year. “It’s clear it’s not easy to run a small economy and a small currency in a big market,” he said yesterday. But not everyone agrees. David Oddsson, the central bank governor and previous prime minister, says Iceland should avoid joining the European Union and the euro because the ECB would ignore the island nation’s economy. Smart words by Oddsson. We still look at the Krona as a “speculative” currency choice.

The gold and silver markets were extremely volatile yesterday, swinging from gains to losses and back again. Both eventually ended with a gain, spurred by investment fund buying and speculation the U.S. dollar will decline. EverBank’s new Metals Select accounts have been a huge hit with investors as we continue to grow this area of our business. Our MarketSafe CD will be offered again in May and June, so if you are looking for a way to invest in gold without risking your principal, contact the trade desk to find out more.

I just found out the Internet is down, so this may be late in getting to you this morning. Ty left last night to join Chuck in Mexico (actually he is playing in an international soccer tourney which just happens to be in the same town as where Chuck is located). Christine is leaving us later this morning to go to Vegas for the weekend, so I gotta get going!

Currencies today: A$ .7556, kiwi .6327, C$ .8896, euro 1.2538, sterling 1.8077, Swiss .7977, ISK 74.70, krone 6.1829, rand 6.1213, forint 210.78, zloty 3.09, koruna 22.67, yen 114.18, baht 37.53, sing 1.5830, INR 45.01, China 8.014, pesos 11.10, dollar index 86.62, silver $12.58, and gold $637.22.

That’s it for today. I’m taking my family to their first Cardinal game at the new stadium tonight. They say the rain will hold off until tomorrow. I sure hope they are right! I hope everyone has a great weekend!

Chris Gaffney
April 28, 2006

The Daily Reckoning