Dollar Holds On to Recent Gains

The bad weather in New York will likely make what was already going to be thin currency markets even lighter. The dollar stayed in a fairly tight range on Friday, with the South African rand (ZAR) being the only currency moving more than 1% (it was down 1.1% versus the US dollar).

So the US dollar was able to hold on to its recent gains and continues to trade near a three-month high versus the euro (EUR). And some believe this recent dollar strength could last well into 2010. I read a story over the weekend that touted the correlation between the dollar and the US stock market. The US equity markets and the dollar are on pace for their first simultaneous two-month gain since 2008. The story reported that the correlated trading reflects growing confidence in the US economy and increasing expectations that the Federal Reserve will start draining stimulus money from the system. Over the past year, the dollar and equities moved in opposite directions, as bad economic data for the US sent stocks down and investors moved money back into the ‘safety’ of the US dollar. But good news emboldened investors and they moved their money back into US stocks and out of the US dollar into higher yielding currencies. The author of the story believes this recent correlation between stocks and the dollar will last, and predicts both will rally in 2010.

I disagree with this prediction. The year-end dollar rally has been fueled by profit-taking and the squaring of positions, and not fundamentals. Bernanke’s Fed won’t put the recovery at risk by raising rates too early. There are also many who believe the US is headed for a double dip as commercial real estate drags our economy back down. With rates remaining low here in the US, the carry trade could weigh heavily on the US dollar. Investors will continue to finance their leveraged moves into higher yielding currencies with US dollar, putting continued pressure on the dollar. So I expect this year-end dollar rally to reverse in the beginning of 2010, with a likely return to its long steady decline.

One currency that could be among the best performers in 2010 is the Norwegian krone (NOK). The Norges bank has already begun to increase rates as their economy begins to expand. A story this morning reported that the Norges Bank Governor Svein Gjedrem would accept a stronger krone to achieve stable asset prices. Gjedrem is expected to keep interest rates ahead of inflation expectations, which should be positive for the Norwegian krone. The Norges bank was the first in Europe to start raising rates, as oil revenue pulled their economy out of recession. Apparently the bank has now accepted that the Norwegian krone will move higher as they raise interest rates.

Another central bank that looks like they are accepting a stronger currency is the Swiss National Bank. The SNB had been selling the Swiss franc (CHF) in order to keep it from appreciating versus the euro. But recently they have been letting the Swiss franc move higher as currency traders have challenged the central bank. It is now pretty apparent that the Swiss central bank is going to let the currency move higher and has given up trying to keep it down. The Swiss franc looks to continue to rally versus the euro, and if/when the dollar begins to fall, the Swiss should be set to rally versus the greenback also.

Uncertainty regarding future interest rate increases is beginning to weigh on the Aussie dollar (AUD). Last week there were a couple of stories that predicted the RBA would pause in February, and some now believe they will hold rates steady for up to 12 months. The Aussie dollar is the second best performer versus the US dollar this year, appreciating by over 26%. The RBA just started increasing rates in 2008, and commodity inflation will likely force further rate increases in 2010. Over the last period of rising rates from 2002 through 2008, the Australian dollar surged 72%. While the Aussie dollar and the RBA have both paused, I feel both will resume their increases in the second quarter of 2010.

Inflation in Asia will likely force a rate increase in India according to a former central bank governor. Former Governor Bima Jalan said India’s central bank needs to drain cash from the economy to check speculation in commodities. “Monetary policy could give a signal that it is worried about inflation” according to Jalan. The current Governor said he discussed the country’s economic situation with the Finance Minister on December 18, fueling expectations that he may tighten policy soon. Higher rates in India will move the rupee (INR) higher.

With a shortened trading week, all of the economic data is being packed into just three days here in the United States. We don’t have any data expected today, but we will see the third quarter GDP numbers along with personal consumption, existing home sales, and ABC consumer confidence tomorrow. Wednesday we will get a look at personal income and spending along with New Home sales and U. of Michigan confidence numbers. And our week will end a bit early on Thursday when we will get the weekly jobs data along with durable goods orders for November.

To recap, the dollar is trading in a tight range with a shortened trading week, Norway is predicted to move higher in 2010, the SNB has given up its fight against a rising currency, and India will likely start increasing rates.

The Daily Reckoning