ECB to Chang Dollar's Direction?

Good day… The dollar continued its assault on the world’s currencies yesterday, as the dollar index moved above the 74 handle. I pulled a chart off of Bloomberg on my way out the door last night, and it showed that the only major currency that was up versus the U.S. dollar yesterday was the Swedish krona (SEK), which managed a 0.07% increase. This dollar rally has legs, but I still question the fundamentals behind the dollars surge. Today may be the day we see the dollar finally make a turn, as the ECB will be announcing their rate decision.

It is not that I expect Trichet to raise rates, but I do expect him to sound hawkish and refocus the market’s attention on Eurozone inflation and away from worries about growth. Two reports out of Germany this morning will bolster Trichet’s hawkish stance. German exports rose more than economists expected in June, defying a stronger euro (EUR) and pushing the trade surplus to a record. Exports increased 4.2% from May, the most since September 2006. German industrial production also increased for the first time in four months with output rising 1.7% from a year earlier. The IMF last month raised its forecast for this year’s German economic growth and said that the global slowdown linked to the U.S. financial crisis was less severe than it expected.

The entire global economy has been dealing with commodity price inflation, but so far, this raw material price spiral hasn’t spilled over to wage pressures. While the severe slowdown in the U.S. economy won’t allow increases in wages, the European economy isn’t in as bad of shape. Lufthansa, Germany’s largest airline, just announced a 5.1% raise to settle a strike. And Lufthansa employees aren’t alone in securing inflationary pay deals in Germany. Negotiated wages jumped 3.5% in the year through April, the biggest gain in 12 years. This wage spiral will keep the ECB focused on inflation, with another interest rate increase possible. ECB council member Klaus Liebscher signaled there might be a need for still higher borrowing costs in Europe, saying in a July 24 interview, “we haven’t exhausted our room for maneuver”.

The euro rallied against the dollar in early European trading on speculation that European policy makers would continue to hold their tightening bias. One of the reasons for the spike in the value of the U.S. dollar has been a shift in interest rate expectations. During the past month, several currency traders have begun to speculate that the next move by the ECB would be a drop in interest rates; while they gambled that the next move by the FOMC would be up. Recent data would suggest these speculations could be completely wrong. The economic downturn looks like it will continue in the United States, keeping the Fed from lowering rates, while the ECB is dealing with a stronger than expected European economy, and spiraling wage pressures. A change in these interest rate expectations could put the dollar back on its long-term trend down, and send the euro back to $1.60 or above.

The Bank of England kept the main interest rate unchanged for a fourth month as they find themselves in the exact same position as our Federal Reserve. Inflation has been accelerating, and the economy is teetering on the brink of a recession. U.K. housing prices dropped the most in a quarter-century and U.K. services, manufacturing, and construction all shrank in July. So the economy is dramatically slowing while inflation is predicted to more than double the 2% target. BOE policy makers split three ways on which direction interest rates should move, so their only choice was to just leave them where they are. England’s economic situation has left the BOE as impotent as the FOMC!

As I mentioned above, the U.K. reported that house prices fell at a rate of 8.8% in July. This morning we will get a better picture of the current status of the U.S. housing market. A report from the National Association of Realtors will probably show that its index of home sales fell for another month. The inventory of unsold homes in the United States stands at the highest level ever recorded. And according to economists, the inventory of existing homes and condos must fall by almost 50% for prices to stabilize. There is an 11.1-month supply of existing unsold homes at the current sales pace, up from 4.6 months in September 2005. Almost one of every 10 U.S. mortgages was in trouble during the first quarter according to the Mortgage Bankers Association.

Those that want you to believe the “worst is over” in the U.S. economic downturn only need to look at the pending home sales numbers, which is usually seen as a leading indicator. The index of pending home resales is expected to have fallen 1% after a decline of 4.7% in May. As we have been reporting for some time now, the falling housing market has far reaching effects on the U.S. economy. While the folks at CNBC have been telling everyone that the worst is over after Paulson and Bernanke came to the rescue of Fannie and Freddie, some very smart people (whom I agree with) are warning that losses will continue to mount.

Nouriel Roubini, the New York University professor who predicted more than two years ago that the United States would fall into a recession because of the bursting of the housing bubble and rising energy prices, is one who disagrees with CNBC. Ty Keough pointed out an interview with Roubini, which appears in this week’s Barron’s. I would encourage any of you who are starting to “drink the Kool-Aid” that Paulson and Bernanke are pushing to read it. In the interview, Roubini predicts that we are in the second inning of a severe, protracted recession, which started in the first quarter of this year and is going to last at least 18 months, through the middle of next year. He goes on to say we can expect a total of $2 trillion of debt related losses in our financial institutions. Roubini states that banks have only started to feel the effects of the housing downturn, and that consumer-credit losses and home-equity loan write-offs will substantially add to their pain.

He ends the interview with this: “Leaving aside the fact that we are going to have a pretty nasty recession and international crisis, the global economy is going to grow at a sustained rate once this downturn is over. There are significant financial and economic problems in the US and that’s why I’m bearish about the US. But the emergence of China and India and other powers is going to shift global economics and politics radically, and the world is going to be more balanced in the future, rather than relying on one engine, which has been the US… I’m quite bullish about the state of the global economy.”

I agree with Roubini’s take on things – and the best way to protect your portfolio? International diversification. Keep a portion of your assets outside of the U.S. dollar, in currencies and precious metals. Investors should view this dollar spike as an excellent opportunity to purchase currencies and metals at cheaper prices, dollar cost averaging to get your overall costs down.

Japan’s government said the economy is “deteriorating,” acknowledging for the first time that the country’s longest postwar expansion has probably ended. “There is a high possibility the economy has entered a recession,” the head of business statistics at the Cabinet office said in Tokyo today. The Japanese yen (JPY) continues to come under pressure due to the weakening economy and the recent move back into carry trades. In these carry trades, investors borrow currencies at low interest rates, sell them, and invest the proceeds into higher yielding investments, earning the ‘carry’. With market volatility easing over the past month, many investors have moved back into these carry trades, pushing the value of the funding currencies of Japan and Switzerland (CHF) down. As in the past, these carry trades can be reversed as quickly as they are put on.

Just in, the ECB left rates unchanged. Now we just have to wait for Trichet’s press conference, which will occur in about 45 minutes. Better get to the currency roundup:

Currencies today 8/7/08… A$ .9106, kiwi .7178, C$.9546, euro 1.5468, sterling 1.9517, Swiss .9474, ISK 79.83, rand 7.4390, krone 5.1734, SEK 6.0846, forint 151.84, zloty 2.0966, koruna 15.54, yen 109.45, baht 33.58, sing 1.3837, HKD 7.8054, INR 42.06, China 6.8643, pesos 9.9398, BRL 1.5775, dollar index 74.08, Oil $120.17, Silver $16.60, and Gold… $882.40

That’s it for today… Chuck traveled out to San Francisco to speak at the money show. This is the first time in several years that I won’t be there, but things are just too busy on the desk as of late. I got to see Chuck at the Cardinal game the other night, and he was excited about getting back out to San Fran and addressing the crowds. I guess Brett Favre is headed to New York. I used to really like him, but this latest move dropped him a few notches in my book. Albert Pujols hit a Grand Slam last night to propel the Cards to another win. Maybe we will have post-season baseball in St. Louis! Hope everyone has a Tub-Thumping Thursday!!

Chris Gaffney
August 7, 2008