Current Account Worries

Good day. Today we will see just how good a grip the dollar bulls have on that hammer they have been swinging. At 7:30 EST, we will get a look at the U.S. current account deficit for the fourth quarter. The markets are expecting another record, with the current account deficit widening to 218 billion from last quarter’s 195.8 billion. If the dollar bulls get their way, the markets will largely ignore this record and talk about the retail sales number or ABC consumer confidence. But, I believe this data will not be positive either and I’m expecting a pretty good sell off by the dollar after the data today.

As readers of the Pfennig know, a bigger shortfall means more dollars will need to be converted to other currencies to pay for imports, putting pressure on an already overvalued greenback. As this current account deficit (actually it is officially called the current account balance, but it has been out of balance so long people have just started calling it the current account deficit!) grows, it increases our reliance on foreign investments. Recently, we have been lucky (some say dumb) enough to attract enough foreign capital to finance this deficit, but we will have to wait until tomorrow’s release of net foreign security purchases to see if our luck will continue.

Yesterday, we saw a small rally in the euro and the yen on speculation that at least one major owner of dollar assets will begin to scale back their investments. The U.A.E., in response to the failed Dubai port deal, announced plans to shift 10 percent of their reserves to euros. Nearly all of the U.A.E.’s estimated $28 billion reserves are now in U.S. dollars. While a 2.8 billion shift of reserves is hardly anything, given the daily volume in the FX markets, symbolically this move is very important. It feeds into the theory that the world may start to turn away from the U.S. dollar as a reserve currency and focus more on the euro. If other Middle Eastern banks follow suit, and if the Iranian oil bourse is successful, we could see additional shifts out of the U.S. dollar. We have continued to hear about Asian central banks beginning to diversify their currency reserves and now the Middle Eastern countries seem to be following suit. Again, the impact on the currency markets is minimal at this time, but it definitely should cause some concern for the dollar bulls in the long run.

As Chuck wrote yesterday, the Blue Light special in Canadian loonies is quickly going away. The Canadian dollar snapped a six-day decline versus the U.S. dollar, as oil and natural gas prices climbed. Commodities account for about one-third of Canada’s exports, with natural gas, oil, and metal all playing important roles in its economy. The Canadian dollar is most highly correlated with the price of crude oil, which enjoyed a 3% rally, yesterday. If commodity prices continue to be strong, we expect the Canadian dollar to continue rallying back from its six-day slide.

Bank of Canada Governor David Dodge, speaking during a bi-monthly meeting of central bankers at the Bank for International Settlements in Basel, Switzerland, said the higher wages workers are receiving with the unemployment rate at a three-decade low, aren’t “a bad thing,” but that wage inflation is still a concern. I expect him to match any further interest rate increases by the United States, which should only serve to strengthen the currency further.

Last night, the Icelandic krona finally reversed course, after yesterday’s slide. The ISK weakened 6.4 percent against the dollar last week, after a report showed the currency account deficit doubled last year. Our friends at Merrill Lynch & Co. said the country’s banks might have too much short-term debt. I don’t know about you, but I don’t fault the banks in keeping their debts short term, with rates as high as they are in Iceland!

The real trouble with Iceland started back on February 21, when Fitch cited Iceland’s current account deficit as one of the explanations for a downgrade of its rating outlook to negative from stable. The currency initially traded off after the release of the Fitch report, but then rallied back making up most of the loss by the beginning of March – only to start the slide again on March 7 with the release by Merrill Lynch. As we have pointed out in the past, this currency is speculative and can be volatile due to the limited amount of currency traded each day (sometimes referred to as “float”). With the “piling on” by Merrill Lynch and others, this latest move down is probably overdone.

Again, this currency is volatile and shouldn’t be the only one you own, but it currently offers the highest interest rates of any of the currencies we deal in and fills the roll of a high yield/speculative portion of a diversified currency portfolio.

The “kissing cousins” down under have continued their breakup with the Aussie dollar having a good day, and the New Zealand dollar turning in one of the worst currency performances. I will start with the bad news. New Zealand retail sales growth stalled in January, sending the nations dollar to a 20-month low amid speculation the pace of the economy will slow enough this year to prompt the central bank to cut rates. We don’t believe this will occur, as the central bank has already stated that rates will not be cut in 2006, but this possibility has caused further selling of the kiwi. Look to sell this currency when you get a chance and move just across the Tasman Sea to Australia, where the future is looking much better.

The Australian dollar rebounded from a 2006-low yesterday, after failing to break through a key level on charts traders watch to predict prices. The currency held above 0.73 cents and has begun to move back up toward 0.74 cents. Australia is the world’s second-largest producer of gold, which rebounded yesterday, giving the Australian dollar some support. Again, we expect the Aussie to hold firm and start its ascent back up toward 0.74 cents and beyond.

Finally, the Japanese yen was one of the biggest movers in Asian trading, moving a full yen to the low 118s. Speculation remains that the Bank of Japan is getting closer to raising interest rates after it ended a five-year bout of deflation-fighting policy, last week. Yesterday, BOJ board member Atsushi Mizuno said, “If expectations for prolonged zero rates grow excessively, that may stimulate demand too much, cause a swing in economic activity, and force the central bank to make drastic policy changes.”

While many currency traders thought the bank would wait until October 2006 to start raising rates, Mizuno’s comments showed the bank is leaning toward raising rates sooner. BOJ Governor Toshihiko Fukui is scheduled to speak on March 16, 2006, and could confirm this view.

Currencies today: A$ .7333, kiwi .6352, C$ .8612, euro 1.1949, sterling 1.7357, Swiss .7624, ISK 70.76, rand 6.287, krone 6.6582, forint 221.52, zloty 3.2953, koruna 24.16, yen 118.40, baht 39.21, sing 1.6254, China 8.0473, pesos 10.745, dollar index 90.53, silver $10.09, and gold $542.95

That’s it for today. I expect the dollar to lose some ground with the release of the CAD and retail sales. Bargain shoppers need to take advantage of the Blue Light specials before they come to an abrupt end. I hope everyone has a great Tuesday!

Chris Gaffney
March 14, 2006

The Daily Reckoning