Carry Trade Rollercoaster

Good day… Well I hate to say it, but the better team won the big game on Saturday night. Mizzou got beat and will have to settle for the Cotton Bowl. Chuck and his family are still down in San Antonio, so I’ll let him bring you the sad details tomorrow, and I’ll get right to work trying to bring everyone up to date on the currency markets.

Carry trades ruled the day on Friday, as investors sold yen (JPY) and Swiss francs (CHF) to buy back into the higher yielding markets. The U.S. dollar was mostly up versus the currencies on Friday, with the Australian dollar (AUD) and pound sterling (GBP) being the only two currencies that were up. But over the weekend, investors got scared again and the carry trade was back off.

Moody’s investor service was the cause of this market trepidation. Moody’s said over the weekend that it is preparing the biggest credit-rating cuts ever because of the subprime mortgage mess. Moody’s warned the markets that it may lower ratings on $105 billion of debt sold by structured investment vehicles (SIVs) which sell short term debt to buy longer-term higher yielding assets. Three SIVs defaulted in the past four months as banks tightened up their lending and these SIVs couldn’t borrow funds needed to remain viable.

A downgrade by Moody’s on these SIVs will force some investors to sell them into a very weak market, as many of the large institutional investors are restricted to buying only investment grade paper. Others who are not restricted could also see negative results, as banks will demand more collateral from investors holding these downgraded securities. As we have been warning, the fallout from the subprime fiasco will continue well into 2008, and will not be restricted to those in the housing business.

So the dollar strength we saw on Friday doesn’t look like it will hang around too long. This is pretty light on data here in the United States, with no major announcements until Friday when we will get November’s employment numbers. Today we will get the ISM manufacturing numbers along with U.S. vehicle sales (both of which will show continued weakness). Tomorrow we only have the ABC consumer confidence number followed by non-farm productivity, factory orders, and ISM non-manufacturing numbers on Wednesday.

On Thursday both the Bank of England and the European Central Bank will announce their rate decisions. While the ECB will almost certainly leave rates unchanged, the BOE decision has economists divided. A majority of economists are predicting policy makers are too concerned about inflation to cut the benchmark interest rate yet. But almost 30% of economists are predicting a quarter point cut to combat surging credit costs, which are threatening economic growth. I believe we will see both the ECB and BOE leave rates unchanged, and the most recent data seem to support my thoughts.

U.K. manufacturing growth unexpectedly rebounded in November and prices at factory gates rose at close to the fastest pace since 1999 according to a report released this morning. The pound sterling rose in early European trading just after this report was released. The U.K. benchmark rate is the highest among the Group of Seven industrialized countries, and these high rates will continue to keep the pound supported.

A separate index of manufacturing growth in the 13-nation euro (EUR) region rose for the first month in five giving additional strength to the euro. Another report released this morning showed that European unemployment fell to a record low in October, with the jobless rate at 7.2% versus 7.3% in September. The October rate is the lowest since the data were first collected in 1993. This increase in employment will hopefully put a floor under European consumer confidence, which had been falling recently.

All of the data this morning supports my feelings that interest rates in the euro region will remain unchanged through the first quarter of 2008. Inflation in the euro region continues to run above targets, and the recent pull back in oil prices won’t be enough to change the hawkish attitudes of both the ECB and BOE. I just don’t think either central bank will want to drop rates with inflation ticking up. Unlike our own Fed, these central banks realize price stability not a surging stock market is their main mission; and they won’t risk their inflation fighting credibility by lowering rates in the face of rising inflation.

The Australian dollar fell over the weekend as a combination of the unwinding of the carry trade and reports of a widening trade deficit combined to work against it. The currency also weakened as the price of commodities that Australia exports stayed near the lowest in two months. The trade deficit expanded to just under A$ 3 million in October from a revised A$ 1.92 million a month earlier. Falling prices of commodities, which contribute about 17% to Australia’s economy was the main reason for the rising deficit. We probably haven’t seen the end of the volatility in the Australian dollar, but remain confident that it will hold its value in the log run. Both China and India will continue to grow, and their demand for commodities will expand with the growth of their economies. This growing demand will keep a floor under the Aussie dollar.

The Chinese renminbi (CNY) fell for a second day after the central bank set the reference rate for trading weaker, suggesting China wants to promote two-way movements to deter speculators from betting on gains. The markets continue to price in aggressive appreciation for the renminbi, but the central bank continues to resist any dramatic moves. China will take “gradual steps” to boost the renminbi’s flexibility, Finance Minister Xie Xuren said yesterday, responding to officials’ calls from Japan, the United States, and Europe who are pushing for faster appreciation.

Currencies today: A$.8819, kiwi .7656, C$ 1.0027, euro 1.4646, sterling 2.0631, Swiss .8846, ISK 61.51, rand 6.8346, krone 5.5292, SEK 6.4005, forint 172.98, zloty 2.4707, koruna 17.9179, yen 110.48, baht 30.70, sing 1.4602, HKD 7.7886, INR 39.495, China 7.4070, pesos 10.9085, BRL 1.7865, dollar index 76.042, Silver $13.825, and Gold… $779.15

That’s it for today… Except for Mizzou we had a pretty good sports weekend here in St. Louis. I was able to watch both the Blues and Rams win their home games this weekend. My son Brendan won his hockey game and then ended the weekend by shooting his first drake Mallard up at our duck club. All in all we had a pretty awesome weekend. I hope everyone has a Marvelous Monday and a great start to their week.

Chuck Butler
December 3, 2007

The Daily Reckoning