ECB Lifts Rates

Good day… The currencies spent the day in rally mode versus the dollar on Tuesday, led by the commodity currencies, which Chuck touched on yesterday. Gold and silver tried to rally but fizzled out as the day progressed. These two are still in a strengthening trend versus the dollar, so these little pullbacks shouldn’t bother long term investors.

The ECB lifted interest rates today, but the euro (EUR) was little changed as the move was widely expected. The markets are now waiting on Trichet’s speech, which may signal further rate increases in order to keep economic growth from fueling inflation. A report released this morning showed German factory orders fell 1.2% from March, but were up over 11.7% from a year ago.

Recent reports show that Europe is growing faster than expected, easily outpacing the United States. Trichet’s recent comments indicate he will sound hawkish in his speech today, which should give the euro further strength and put it back on the road towards $1.40.

We now are waiting on the BOE who may just surprise us with a larger than expected increase tomorrow. The pound sterling (GBP) continued to hold on to its recent gains and is within ‘spitting distance’ of the $2.00 figure. U.K. consumer confidence reached the highest level in 18 months in May, as Britons became more optimistic about their jobs and the economy, a survey showed today.

While Chuck went out on a limb pretty early with his call for a raise in rates, a majority of economists still expect the central bank to keep rates on hold. I side with Chuck and expect at least a 25 bps rate increase as the BOE tries to deal with inflation which has stayed stubbornly above 3%, a full 1% over the BOE’s target. Any increase in rates should move the pound back above $2.00 where it is likely to stay.

Chuck left me his thoughts on the G8 meeting which is happening this week over in Europe:

“I mentioned yesterday that there will be a G8 meeting this week, and how they have turned these things into boondoggles in recent times… However, there are rumors going around, someone’s underground… But wait… There are rumors going around that Treasury Secretary Paulson is going to make a speech ahead of the G-8 meeting to touch on progress with China. I find this to be interesting given the fact that there are two bills working their way to the floor, regarding China.

“The first bill, which is scheduled to be presented in mid-June, is sponsored by Senator Schumer, who said, ‘We’re working on a tough WTO-complaint legislation that will force China to do what it should be doing on its own.’

I think this is why Paulson is speaking before the G8 meeting, to set the stage for a potential showdown with China…”

There has been nothing but good news coming from Australia recently, as reports showed that their economy grew at the fastest pace in more than three years. This report follows yesterday’s data, which showed that their current account deficit narrowed in the first quarter and building approvals were stronger than expected.

Growth in the land down under has been driven by consumer spending and business investment, as mining companies in the world’s largest exporter of iron ore and coal expand to meet surging Asian demand. The currency has moved to the highest since 1989 on expectations the central bank will raise rates to ward off inflation.

The good news on Australia also spilled over to their neighbors in New Zealand. Our Corporate FX guru, Ashish, sent us a note from Goldman Sachs (NYSE:GS). Goldman’s technical charts show that a kiwi (NZD) close above 0.7495 indicates that the next stop would be 0.7770! Of course I would say that fundamentally as long as the carry trade continues, kiwi should be underpinned!

Another benefactor of the carry trade has been the Icelandic krona (ISK), which had sold off over the past two days. Iceland came charging back overnight, gaining the most in two weeks against the euro after an economic report showed the current-account deficit narrowed more than forecast. The krona remains the best performing currency versus dollar this year as interest rates have continued to keep the krona one of the favorites of the ‘carry trade’. While Iceland’s currency has given our investors a very nice return this year, we like to remind everyone just how volatile this currency is and it may not be a bad time to be taking some of these gains off the table.

Finally, Chuck sent me a follow-up on a subject he has been writing about, the premium the markets are currently putting on risk:

“Talk about timing! I’ve been talking about the lack of risk aversion, and the dolt mentality of traders these days, in rewarding currencies that have economies with high inflation. To these guys, high inflation means higher interest rates… And in my opinion that’s OK, as long as the country’s Central Bank was raising rates to fight that inflation from the beginning.

“Well, yesterday I received an email from my trader friend at the Royal Bank of Canada… And here’s what they had to say: ‘In fact, as a paradigm shift in central banks’ priorities sees inflation moving up the agenda, we expect out-performance of high inflation currencies to be reinforced, not reversed.’

“So… Let the good times roll for the high yielders, eh?

“Where does that put the euro? Ahhh grasshopper… The euro is like goldilocks… Interest rates aren’t too high… They aren’t too low… They’re just right! And that will insulate the euro from the bad stuff that will happen to high yielding currencies when the carry trades unwind!”

Currencies today: A$ .8411, kiwi .7502, C$ .9413, euro 1.3508, sterling 1.9914, Swiss .8212, ISK 62.55, rand 7.19, krone 5.978, SEK 6.9105, forint 186.99, zloty 2.8335, koruna 21.02, yen 121.00, baht 32.69, sing 1.5319, HKD 7.8115, INR 40.67, China 7.6360, pesos 10.8295, dollar index 81.89, Silver $13.65, and Gold… $667.90

That’s it for today… We will get Nonfarm productivity and unit labor costs released this morning, neither of which should be market movers. Rates continue to increase in Europe, while they remain stable here in the United States. Not a good scenario for the dollar! It is a beautiful morning here in St. Louis, but the weather is expected to get more summer-like today (90 degrees and high humidity!). Thanks for all the kind notes concerning my daughter Lauren, she pulled through surgery just fine! Hope everyone has a great hump day!!

Chuck Butler — June 06, 2007

The Daily Reckoning