Dollar Falters Overnight on Interest Rate Speculation

It can be a struggle to find things to write about when the markets aren’t moving much. That has been the case with the currency markets over the past few days, as the dollar has been trading in a fairly tight range. It felt like the dollar had the possibility to break out of this range yesterday, as we got a couple of different reports that looked to push the dollar higher.

Tuesday started off with the dollar moving higher versus the euro (EUR) as a result of the drop in German business confidence which Chuck wrote about. The drop in German confidence was the first in nearly a year, and comes as economic growth in the European region seems to have stalled out. The dollar got a further boost after the release of a gauge of US consumer confidence fell. The Conference Board said its consumer confidence index dropped to 46 in February from a level of 56.5 the previous month. This dramatic 18.5% drop surprised economists who had predicted that the number would remain largely unchanged.

The drop in confidence caused investors to start to move back into the US as a ‘safe haven’ throughout most of the trading day. By the end of the trading day, the dollar had appreciated versus all of the major currencies with one exception, the Japanese yen (JPY). The yen soared over 1% versus the US dollar, and was up even more versus the rest of the major currencies.

Most of the currency stories that I read last night in preparation for this morning’s Pfennig called the yen a ‘safe haven’ currency along with the dollar. And while the yen and dollar do both move higher when risk is taken off the table, it is not because investors fell ‘safer’ in these currencies, but rather is a result of the reversal of ‘carry trades’. When investors feel confident about the global economies, they borrow funds at the very low interest rates available to them in Japan and the US, and invest these funds into higher yielding assets. These highly leveraged transactions are what have driven the currency markets over the past few years. But if and when investors begin to get nervous, these leveraged carry trade positions are some of the first that are reversed. In reversing these carry trades, the investors purchase Japanese yen and US dollars, driving these currencies higher.

The yen also got some help from strong export figures released yesterday. Japan’s exports climbed at the fastest pace in almost 30 years in January, helped by increased demand in China. Japanese shipments were over 40% higher than a year earlier, the biggest increase since February of 1980. I helped Chuck research a piece for this month’s Review & Focus which talks about the growing consumerism in China, and the impact it will have on global markets. Japan’s economy certainly seems to be well-positioned to take advantage of a growing Chinese middle class, and their increasing appetite for consumer goods.

Overnight, the dollar lost some ground versus the European currencies, as traders seemed to realize the longer-term impact that a weaker US consumer would have on the US economy. Currency traders had taken the dollar higher over the past few weeks after predicting interest rates would be rising here in the US. These predictions began after US GDP rose dramatically during the fourth quarter, and heated up when the Fed moved the discount rate higher last week. But the negative consumer confidence numbers have caused many to question these predictions of higher rates. So while some were moving to the US on safe haven concerns, others were decreasing their US dollar positions as they dampened their calls for higher interest rates in the US. These two different dynamics have combined to keep the dollar in a fairly tight range.

Federal Reserve Chairman Ben Bernanke will probably provide the markets with some volatility over the next few days as he testifies on Capitol Hill. Bernanke will deliver his semi-annual monetary policy report before the House Financial Services Committee at about 10 AM today and will testify before the Senate Banking Committee tomorrow. The markets will be waiting to hear what he plans to do with monetary policy as the US economy struggles with the worst jobs slump since the Great Depression. While the congressman and senators grill him on the unemployment situation, investors will be watching for any hints on the timing of the next move in interest rates.

As I pointed out earlier, some investors read a bit more into the Fed’s discount rate hike than I think they should have. European investors in particular seemed to take the discount rate move as an indication that the Fed would quickly move to raise other US interest rates. But several members of the FOMC have recently come out to assure investors that interest rates here in the US are going to remain low for an extended period. Bernanke will likely tell congress that last week’s increase in the discount rate is not a prelude to higher benchmark borrowing costs. This could reverse some of the dollar buying that we saw following last week’s discount rate move.

So the dollar gave back some of its gains overnight, and is lower versus the commodity-based currencies of Norway (NOK), South Africa (ZAR), Australia (AUD), and New Zealand (NZD). The rand moved the most among the emerging market currencies after a government report showed South Africa’s economy expanded in the fourth quarter of last year at the fastest pace since 2008. The South African economy grew at an annualized 3.2% in the final quarter of last year versus just 0.9% during the previous quarter. The number was substantially higher than economists had predicted and gave a boost to the rand.

Both the Australian and New Zealand currencies rose versus the US dollar for the first time in two weeks on renewed optimism that the nations will retain their yield differentials. The currencies had lost ground to the dollar as traders predicted that rates in the US would be moving higher soon. But the drop in consumer confidence, and Bernanke’s testimonies today and tomorrow, caused many to reverse their calls for higher rates here in the US. Meanwhile, interest rates are predicted to continue to move higher in these commodity-based countries.

But one commodity currency that didn’t move higher was the Canadian dollar (CAD), which fell the most in almost five weeks. The loonie fell for a second straight day as US consumer confidence weighed on export prospects. Yes, Canada is still dependent on a strong US consumer; so the data yesterday caused many to sell their investments in the loonie. A drop in crude oil prices also caused some selling pressure on the Canadian dollar. Chuck gave a wink to this currency yesterday, as these lower prices could be a good buying opportunity.

And I will end today’s pfennig with something Chuck sent me last night:

“David Galland had a great piece in his letter yesterday, that needs to be pointed out to everyone, everywhere, before they begin to pop open the champagne bottles!

“The National Association for Business Economics (NABE) released their latest forecasts for the US economy and the forecasts are rosy… Very rosy… ‘The NABE forecast panel expects the economic recovery to remain firmly on track. Real GDP growth of 3.1 percent is projected over the four quarters of 2010, nearly identical to last November’s prediction of 3.2 percent. That pace is also expected for 2011, comparing favorably with the panel’s 2.7 percent assessment of the economy’s underlying trend.’

“And here was my good friend David Galland’s response to this forecast by the NABE…

“‘Good news? Well, don’t break out the champagne just yet. This is the same group that in February of 2007 came out with the following:

“‘“The US economy appears to be transitioning to a sustainable growth path. The NABE forecast panel sees real GDP (gross domestic product) growth starting 2007 modestly and then gaining momentum after midyear. On a fourth-quarter-over-fourth-quarter basis, real GDP is expected to grow 2.8% in 2007, the same pace predicted in the last two surveys and in the middle of the central tendency of the range recently projected by members of the FOMC.”

“‘The NABE panel expects growth to then average a somewhat stronger 3.1% over the four quarters of 2008. This pace would be somewhat higher than the group’s estimation of the non-inflationary rate of real growth, which stands at 3%.’

“And we all know just had badly those forecasts turned out to be, now don’t we!”

To recap… Dollar drifted higher yesterday, but moved back down overnight… Bernanke to testify before congress.. And the commodity currencies begin to move higher again but leave the loonie behind.

The Daily Reckoning