BOJ leaves rates unchanged

Good day… As widely expected, the Bank of Japan voted 8-1 to keep its benchmark interest rate unchanged for a sixth straight month. Economists were certain of this outcome, so the Japanese yen (JPY) didn’t really move on the rate announcement. The only good news resulting from this meeting is that the decision was not unanimous. The last time we had a split vote, rates were raised at the following meeting. So everyone is now looking for Japan to raise rates at their meeting next month. Unfortunately, unless policy makers decide to start making whole percentage point moves, it will take several months to get rates back up to more normalized levels. A single 0.25% move, which is widely expected (and already priced into the markets), will not move the yen. But after a couple of these small moves, Japanese investors may start moving funds back into their home currencies. I still think the yen is a good buy at 120 plus for very patient investors; but you will have to stick with it for the long haul.

The dollar fell to another record low against the euro (EUR) as concerns regarding the U.S. subprime meltdown dominated the currency markets. Signs of a housing slump will deepen reinforced expectations that the Fed will keep interest rates unchanged this year, adding to the dollar’s decline. A report by the National Association of REALTORS predicted that 2008 single-family housing starts would fall to the lowest level since 1995. Housing will continue to be a drag on economic growth all the way through 2008.

We have reported at length about the subprime mortgage mess and the slowdown in U.S. housing, so I thought you would like to see some other thoughts on the matter. Our friends at Agora Financial publish a great recap of all the top stories called The 5 Min. Forecast. Here is what they had to say about the mortgage mess yesterday:

“This week and last, Moody’s has been taking heat for waiting too long to respond to the housing bust. They’ve now downgraded 399 bonds. S&P’s threat puts another 612 at risk. In their press release, S&P said they expect home values will decline 8% on average between 2006-2008.

“‘On the numbers,’ reports Eric Fry of Rude Awakening, ‘the U.S. economy is slowing, the U.S. dollar is faltering, the housing market is limping, the mortgage market is withering and the leveraged world of credit-derivative exotica is imploding. The last of these worrisome items fascinates – and worries – us the most.'”

The currency markets have recently been trading on interest rate differentials, so now that most economists are coming to the realization that the FOMC will be unable to raise rates anytime soon, the yield spread that U.S. assets have enjoyed is predicted to narrow or disappear.

Investors were willing to look past our massive trade and budget deficits when they were getting fat interest rates differentials; but now these spreads are tightening, and investors are looking elsewhere for their investments. It is not a pretty picture for the U.S. economy. No matter what the Fed would like to see, investors are going to start demanding more interest to entice them to buy U.S. debt. So the economy is going to slow due to housing, but interest rates are likely to be forced up; a worst case scenario for the U.S. economy.

Today we will finally get some data here in the United States that could impact the markets. The U.S. trade deficit is predicted to have widened to $60 billion, as a jump in oil offset record exports. The gap in goods in services is not expected to rise much more, as a weaker dollar should help exports to the growing economies of Europe and Asia. But even if it doesn’t grow, the huge deficit will continue to put pressure on the dollar.

Other data out today is expected to show that the employment picture in the United States is fairly stable. Weekly jobless claims are expected to come in at 315K, just below last week’s 318K. Good news for the United States may come in the form of the monthly budget statement, which is expected to show that the government’s surplus rose in June. But with market sentiment against the dollar, I don’t expect any of this data to change the recent direction of the dollar. At best, look for the dollar stabilize and hold at these levels today.

Europe’s economy grew faster than previously estimated in the first quarter, and is set to sustain its momentum through the year, European Union reports showed. The regional economy expanded 0.7% from the fourth quarter, when it grew 0.9%. That compares with the 0.6% estimate last month. Europe’s economy is set to expand more than the United States for the first time since 2001, as falling unemployment and business and household confidence – each near a six-year high – boost demand. “The medium term outlook looks favorable and conditions are in place for the euro area economy to grow at a sustained rate,” ECB President Trichet told the European Parliament yesterday.

Trichet and his compatriots at the ECB continue to indicate that the bank is preparing to raise interest rates as soon as September. The bank reinforced that signal today in its monthly bulletin, saying that the current benchmark rate still supports growth. The strongest economic expansion since 2000 will encourage companies to lift prices and wages as energy costs increase. We still expect the euro to trade up to $1.40 and beyond on positive rate expectations.

The Swiss franc (CHF) rose to the highest level since April against the dollar as investors begin to unwind “carry trades” funded with the franc. The Swiss franc has a lot of ground to make up versus the euro, so we expect to see it continue to be one of the best performers. Switzerland’s main interest rate is the lowest of the major economies outside of Japan, and I expect them to be even more aggressive than the ECB in rate increases through the end of this year.

India’s industrial production growth slowed for a second month in May as the highest interest rates in five years crimped demand and currency gains weakened exports. But this slowdown shouldn’t concern investors, as rates of growth are still among the highest in the world. Output at factories, utilities and mines rose 11.1% from a year earlier, following a revised 12.4% increase in April. The Reserve Bank of India, which has allowed the rupee (INR) to gain to a nine-year high to make imports cheaper and curb inflation, will probably leave interest rates unchanged at its next policy meeting on July 31. But with growth remaining above 10%, don’t expect rates to come down anytime soon. The rupee remains a good alternative to the “slow and steady” Chinese renminbi (CNY).

Currencies today: A$ .8630, kiwi .7821, C$ .9510, euro 1.3787, sterling 2.0325, Swiss .8320, ISK 60.31, rand 7.025, krone 5.7509, SEK 6.6315, forint 178.95, zloty 2.7275, koruna 20.5657, yen 122.11, sing 1.5156, HKD 7.8160, INR 40.5025, China 7.5690, pesos 10.7957, dollar index 80.547, Silver $12.98, and Gold… $664.95

That’s it for today… What a beautiful night we had here in St. Louis. Temps were right around 75 with lower than normal humidity. Spent the evening at the local pool with my kids, a perfect summer evening. Today I’m going to try my hand at currency trading, with Chuck and Jen out Kristin doesn’t have a backup. Look out markets, here I come! Hope everyone has a good Thursday!!

Chuck Butler — July 12, 2007

The Daily Reckoning