Dollar Falls on Slower Growth

Good day. The dollar ended the week lower versus the euro and the yen as the market focus has clearly shifted from the events in Lebanon back to interest rate differentials.  With just over a week to go before the FOMC decision, I expect the currency traders to continue to sell dollars in exchange for yen and euros, as we continue to see signs that the next Fed move up will be its last.

The numbers Friday were pretty much as expected, with GDP coming in slightly below expectations at 2.5% for the second quarter. The dollar probably would have dropped even further on this data, but the personal consumption data came in a little higher, limiting the downside. As I said in Friday’s Pfennig, the PCE number is the Fed’s main gauge on inflation. It increased 2.9% in the second quarter compared to a revised 2.1% in the first. This higher number caused some to predict the Fed will need to continue to raise rates after the August meeting. But even with higher inflation, I believe the Fed will pause after next weeks move and the dollar will continue to sell off.

While we will get a ton of data this week on the U.S. economy, tomorrow’s PCE deflator is one number that could move the markets. If the deflator comes in higher than the predicted 3.3% rate, currency traders could rally the dollar with the thought that the FOMC will need to continue to move rates higher. We will also see the ISM manufacturing number along with construction spending and pending home sales on Tuesday, which could offset the PCE data. Finally, we will get July’s jobs jamboree on Friday, which will set us up for next Tuesday’s FOMC decision.

The Euro got help in its rally versus the U.S. dollar with data out this morning that showed European’s confidence in the economy unexpectedly rose to the highest in more than five years in July. Inflation was also reported to be increasing at the fastest pace since October, strengthening the argument for the ECB to increase rates this week.  Consumer prices gained 2.5%, unchanged from the past two months, but still topping the ECB’s target of just below two percent. It now looks like a sure bet the European Central Bank will raise rates on Thursday, speeding up the timing of rate moves to every two months from quarterly.

Another piece of data from Europe this morning showed German retail sales rose more than expected in June, as World Cup fever gripped the nation. An increase in the sales tax, which will take place next year in Germany, is also causing households to make major purchases a little earlier. Sales rose 1.9% from May, nearly double the predicted amount. Germany is now on course for the fastest pace of expansion since 2000. With solid growth and interest rates that have just started up, we believe the Euro should continue to rise versus the U.S. dollar, and will likely move up back over 1.30 by year end.

The pound sterling will likely continue to rally today as U.K. mortgage approvals increased at the fastest pace in five months. House prices in the United Kingdom also increased, matching the fastest pace in two years this month helping to sustain a pickup in consumer spending. The U.K. economy, Europe’s second largest, expanded at the fastest rate in two years in the second quarter, buoyed by consumer spending. Currency traders now believe the Bank of England will raise its lending rate by the end of the year after lowering it last August.

Near-record oil prices and the prospect of higher interest rates continue to push Norway’s krone. Norway is now close to matching its neighbor Sweden in currency return versus the U.S. dollar, as both have risen just under 10% this year. As Chuck has been telling us over the past few months, the currency markets have begun to focus on the countries with sound economic fundamentals. Both Norway and Sweden have current account surpluses and hawkish central banks, which will keep inflation away. While current interest rates in both countries are below those in the rest of Europe, strong growth and oil revenues will likely keep inflation concerns at the forefront of their respective central banks. We expect these currencies to continue to perform nicely over the rest of the year. One great way to take advantage of these currencies is our new Euro Trax Index CD, which is comprised of euros, Swedish krona, Norwegian krone, and Swiss francs. This is a rock solid currency CD!!

The yen advanced to its highest in more than two weeks against both the dollar and euro after a government report showed industrial production in Japan rose to a record in June.  This higher growth may push the Bank of Japan to lift interest rates a second time this year. The yen is also benefiting from the reversal of the carry trade. Investors are now taking off their yen shorts, which have built up extensively over the last few years.  I would expect to see even more buying of yen today as Japan’s industrial production numbers continue to point toward further rate increases by the BOJ.

Currencies today: A$ .7657, kiwi .6168, C$ .8898, euro 1.2757, sterling 1.8650, Swiss .8118, ISK 72.83, rand 6.88, krone 6.16, SEK 7.24, forint 213.32, zloty 3.08, koruna 22.37, yen 114.37, baht 37.84, sing 1.5778, INR 46.56, China 7.969, pesos 10.85, dollar index 85.34, silver $11.44, and gold $635.80

That’s it for today. It was a hot weekend here in St. Louis! Too bad the Cards weren’t so hot versus the lowly Cubbies; they got swept again in Chicago. Ugh! Chuck will be back in the saddle tomorrow. Hope everyone has a great start to their week!!

Chris Gaffney
July 31, 2006