Carry Trade Continues to Unwind

Good day… The unwinding of the carry trade continues to dominate the currency markets, as the Japanese yen strengthened again over the weekend and is now up almost 4.5% in the past five days. And the worst performers over the past five days? The high yielding currencies of South African rand (-5.6%), New Zealand dollars (-4.8%), and the Icelandic krona (-4.5%). More on the carry trade later, but now let’s check in to see what is going on in the U.S. markets.

After Thursday’s plethora of data, we got a break on Friday with only the U. of Michigan Confidence number released. This number was revised down slightly at 91.3, compared to the last estimate of 93.3. With a lack of any real data, the markets focused on reported troubles in the subprime mortgage market as a big subprime lender, New Century Financial Corp. delayed the filing of its earnings. Also, a story in the WSJ reported that Countrywide Financial, the largest U.S. home mortgage lender, saw a sharp increase in late payments in 2006.

In typical ‘late to the rescue’ form, Federal bank regulators demanded tougher standards for subprime loans on Friday, saying that they’re worried that borrowers of adjustable rate mortgages may not understand the risks associated with them. These loans have been the talk of the markets for the last five years, and the Federal regulators are just now figuring out that some borrowers may not understand them?!

The Fed has been more than happy to just sit and watch as U.S. consumers use their homes like ATMs, which has allowed them to continue the ‘borrow and spend’ cycle that has kept our consumer driven economy rolling along.

But now that interest rates are in danger of creeping up, the government wants to step in to protect these consumers. A little late, don’t you think? Unfortunately, it’s likely that this CYA by our government is just beginning. The massive rebalancing of the global markets that Chuck has been writing about is going to cause some pain, and our legislators will be looking everywhere to spread blame.

Today we will see the ISM non-manufacturing data released, which is expected to show a drop in service industry growth for the month of February. Tuesday we will get the non-farm productivity, unit labor costs, pending home sales, factory orders and ABC consumer confidence, none of which are expected to give the U.S. markets support. Wednesday we will get to see the Feds beige book, along with a report on consumer credit and MBA mortgage apps. Thursday we get the normal weekly jobs data and then close the week out with a ton of data on Friday including January’s trade balance, wholesale inventories, and the monthly employment data. Looks like this could shape up to be another negative week in the U.S. markets.

I reported late last week that both Bernanke and St. Louis Fed President Poole were scheduled to speak. As expected, both tried to calm the markets. Poole said that while there “could be a recession,” one isn’t likely. “We do not see a recession coming,” Poole said. And they didn’t see a problem with all of those adjustable rate mortgages being sold to borrowers, or a massive run up in housing prices, or runaway government spending either!! I’m not real confident in their eyesight right now; it seems like they have been overlooking some pretty obvious economic problems.

As I said in the opening paragraph, the unwinding of the carry trade continues to dominate the currency markets. The yen continues to strengthen, approaching the next big resistance level of 114.60. If we see it trade through this level, the next stop is a test of the 110 level. Japanese investors continue to bring money back home to pick up bargains created by last week’s massive sell-off in the equity markets.

The yen has also gained strength from reports that Japan’s largest companies increased spending at the fastest pace in at least four years last quarter, signaling the economy may have grown more than initially estimated by the government. Investment surged 16.8% in the three months ending December 31, the fastest increase since the government started tracking the figure in 2002. The pace of growth means the fourth quarter’s gross domestic product figures may be revised higher, helping to justify last month’s rate increase by the BOJ.

Moving closer to home, Canada’s economy grew at just 1.4% in the fourth quarter, the slowest growth since 2003. Manufacturers sold their inventories to meet demand and consumer spending eased. As we have been warning readers, Canada’s economy is still very dependent on the United States, so a slowdown here will continue to spill over to Canada. Weaker gold prices and the tax on trusts have also contributed to the loonie’s sell off. We continue to warn against investments in the Canadian dollar, as we think there are better possibilities in the European and Asian markets.

The Australian dollar has seen some weakness in sympathy with the sell off of the New Zealand dollars, but I believe this weakness is simply an opportunity to purchase the Australian dollar. Australian company profits rose in the fourth quarter as a jobs boom fueled consumer spending and retail earnings in the Asia-Pacific region’s fifth-largest economy.

Surging Chinese demand for commodities sparked an investment and construction boom last year for miners and energy producers, driving the fastest jobs growth in 17 years. The Australian dollar remains one of the most popular investment choices at EverBank.

I wanted to comment on the dramatic sell off in the price of gold and silver, but I’m out of time this morning. Hopefully Chuck will have some words of wisdom on this tomorrow.

Currencies today: A$.7747, kiwi .6758, C$ .8467, euro 1.3100, sterling 1.9212, Swiss .8194, ISK 68.94, rand 7.495, krone 6.2437, SEK 7.1233, forint 194.61, zloty 2.9875, koruna 21.51, yen 115.54, baht 33.17, sing 1.5294, HKD 7.8147, INR 44.63, China 7.7415, pesos 11.23, dollar index 84.13, Silver $12.57, and Gold $639.05

That’s it for today… Chuck will return this evening for a quick day on the desk only to fly back out with me on Wednesday. Looks like we are going to continue to see some nervous markets; try to keep calm and don’t get caught chasing. Hope you all have a great start to your week! Happy Monday!!

Chuck Butler — March 05, 2007

The Daily Reckoning