Currency Markets Held Hostage by Rising Oil Price

Good day… Chuck and Mike are headed down to sunny Florida this morning, so you are stuck with me for the next couple of days. This morning’s Pfennig is somewhat of a cooperative effort, though, as Chuck left me a good bit of information yesterday on his way out the door. So I will let Chuck start things out this morning with his views on what occurred in the currency markets yesterday. Take it away Chuck:

Well… Once again, the lofty currency levels of the previous night were wiped out by the NY traders… Very strange, indeed… But, here’s an alternative thought to what I normally attribute these NY sell-offs to… And that is… The price of oil was on the rise again… And if there’s something that could throw a spanner in the works of global growth, it’s the price of oil… So… We’ve got that to think about, eh?

The Bank of Canada (BOC) left rates unchanged yesterday, as I suspected they would, and their statement afterward, left a lot to be desired for those looking for signs that interest rates could be going up at future meetings. However, personally, I don’t see how the BOC or BOC Governor Carney, can continue to ignore strong economic data, like the surprisingly strong fourth quarter GDP report that printed on Monday… The Canadian dollar/loonie (CAD) lost ground after the rate announcement and the somewhat non-committal statement, but even a disappointing BOC meeting can’t knock the complete stuffing out of the loonie, not with oil prices on the rise again!

Well… Big Ben Bernanke spoke to the Senate Banking Committee yesterday… This used to be called the Humphrey-Hawkins testimony, but that bill that required the Fed Chairman to testify before the Senate Banking Committee twice a year, expired long ago, but it continues today, in an attempt to keep the spirit of the bill alive.

I told you on Monday that the first shoe to drop this week for the dollar would be Big Ben telling the committee that the FOMC intended to keep interest rates near zero. He did just that… In addition, he talked about the threat of higher oil prices and the damage they would do to the economy… He then went on to say, “[the] economy still needs the support of its $600 billion bond-purchase program, downplaying runaway inflation risks that others have raised.

“The most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in US consumer price inflation.”

He also discussed that the Fed was “ready to step in”…. You know what that means, right? More QE!

So… I think that the Fed, along with the Bank of England, is not taking inflation seriously… And if the ECB doesn’t talk about it tomorrow, you can add them to the list… They believe that this is a short-term phenomenon, and it will go away… I personally think they are wrong! So, let’s hope that ECB President Trichet doesn’t get fooled into thinking that the BOE and Fed “know what they are doing”!

As Chuck suggested, the currency markets were held hostage by the rising price of oil. As oil prices rose above $100 a barrel for a second day, the dollar lost ground against most of the major currencies and the metals moved higher. The top performing currency over the past 24 hours was the South African rand (ZAR), which rallied on the back of higher gold prices. The Norwegian krone (NOK) was the second best performer, which should be expected as the higher oil prices would be expected to boost the currency of the largest non-OPEC exporter of oil. The Swiss franc (CHF) also moved higher as investors sought out the “safe haven” from the unrest in the Middle East.

The euro (EUR) rallied a bit after a report showed that European producer-price inflation accelerated more than forecast. January’s factory-gate prices in the euro region were up 6.1% from a year earlier, after increasing 5.3% in December. The higher prices could force the hand of the ECB, which is expected to keep rates steady at their monthly rate meeting which ends tomorrow. Higher oil prices, and a recovering economy will put some additional pressure on Trichet to start to boost rates, as Eurozone inflation is predicted to average 2.2% this year. The ECB has set a target rate for inflation of 2%, so I would expect them to get aggressive in their attempt to keep prices stable.

While Bernanke is trying to convince everyone the price spike will be “temporary,” ECB Executive Board member Stark is more concerned. Stark said last week that the ECB is “prepared to act decisively and immediately if needed” to maintain price stability. Most economists believe the ECB will hold off any rate hikes until after the summer, with a majority predicting the first move by the ECB in September. But a stronger economy, and higher prices will likely force an earlier move, which would send the euro higher versus the US dollar on a combination of interest rate differentials and inflation expectations. The only thing curbing a strong rally by the euro is the European sovereign debt crisis, which hangs over the euro like the sword of Damocles.

Data released in the UK showed that manufacturing continues to recover. A UK index of manufacturing stayed at a record high in February, remaining at 61.5, which is the highest level since the survey began in 1992. The good manufacturing numbers have led to stronger UK employment, indicating that the recovery in the UK will continue. The pound sterling (GBP) strengthened to above $1.63 for the first time this year and is now up nearly 4.5% versus the US dollar during 2011. The pound is the third best performing currency in 2011 just behind the Norwegian krone and Swedish krona. Higher oil prices will also help the pound sterling, which exports crude oil to several other European countries.

The worst performer versus the US dollar so far in 2011 is the New Zealand dollar (NZD), which fell again overnight. Prime Minister John Key continued the sell off when he said he would “welcome” an interest rate cut to bolster the economy. Mother nature hasn’t been kind to the lands Down Under, and Prime Minister Key wants his central bank to help boost the economy with a rate cut in order to combat the economic impact of the earthquake in Christchurch. Traders have now priced in a 25 basis point cut in rates for New Zealand during their March 10 meeting, and many bet the cut could be as large as 75 basis points. The kiwi is a popular alternative for Asian investors, who buy the currency in order to pick up the additional interest. So a cut in rates would definitely hurt the value of the New Zealand dollar.

Rate expectations have also caused a drop in the Aussie dollar, as economists are now predicting that rates will remain on hold in Australia for the near future. Most, including this Pfennig writer, had expected the RBA to be bullish and move rates higher in order to combat rising inflation. But RBA Governor Glenn Stevens said inflation would remain within their target range of 2 to 3 percent over the next year, warranting a “wait and see” attitude with regard to rates. The recent natural disasters in Australia are expected to shave a percentage point off of growth in the first quarter, and some believe the RBA could be forced to follow New Zealand in bringing down rates to spur further growth. But recent data showed that consumer prices are on the rise, and the RBA will not cut rates with rising inflation. The Aussie dollar (AUD) will hold above parity, but any further rise may be limited by concern over the longer term impact of the floods and cyclone which battered Australia over the past few months.

To recap… Chuck is off to Florida, but updated us on the currency markets before he left. Bernanke and the BOE aren’t taking inflation seriously, hopefully the ECB will. UK manufacturing boosted the pound sterling. Rate cuts are now expected in New Zealand and the kiwi got sold off because of these expectations.

Chris Gaffney
for The Daily Reckoning