Euro Hits a New Record High

Good day… The dollar slid to a record low against the euro (EUR) yesterday with investors continuing to focus on the narrowing interest rate differentials. The euro shot up to $1.3787 yesterday, surpassing the previous record set in December 2004. Other currencies also moved up versus the dollar as the pound sterling (GBP) moved above $2.03 and the Chinese let the renminbi (CNY) continue to climb. Even the Japanese yen (JPY) got in on the fun and moved below 122 for the first time in a month to trade at 121.55.

Helping to drive the dollar down was Standard & Poor’s warning that it may cut ratings on $12 billion of bonds backed by subprime mortgages. S&P is a little slow to the realization of the huge mess the subprime market is in; but better late than never. The possibility of a cut in ratings has thrown cold water on all U.S. dollar denominated investments with the exception of Treasuries. Investors sold non-government bonds and stocks to move into safe havens including U.S. Treasuries (yes, even with all the current mess the U.S. Treasuries are still seen as the safest investment for U.S. dollar). Many foreign investors simply moved out of the dollar all together, causing the slide in the greenback.

Readers know exactly where Chuck and I stand on the U.S. housing market, and the rest of the investment world finally seems to be realizing just how long and deep the slowdown is going to be. DR Horton, the country’s largest homebuilder forecast its first quarterly loss as a public company, and U.S. home improvement retailer Home Depot lowered its 2007 earnings outlook because of the deteriorating housing market. Homebuilders failed to adjust quickly enough to the slowdown in demand and have a large inventory of new homes that are sitting on the market. Driving home last night, I listened to interviews with two separate economists who predicted we won’t see the worst of the housing market downturn until this time next year, and that the recovery would take at least 2.5 years.

We will have to wait and see what our fearless Fed leaders have to say about this most recent sell-off. As we have reported, the FOMC members still seem to believe the U.S. economy will “weather the storm” of the housing slowdown. Bernanke will now have to defend this rosy outlook for the U.S. economy at a time when criticism over the Fed’s preferred measure of inflation is heating up. Yesterday Bernanke tried to defend the FOMC’s use of CORE inflation (which excludes food and energy) as their preferred measure of inflation. European central banks have never concentrated on this core number and instead use M3 as their preferred gauge. Inflation, calculated according to the Fed’s core index of personal-consumption spending declined to 1.9%; just below the Fed’s implied target of 2%. However, including food and energy, inflation remained at 2.3%.

So the Fed continues to use the number that “fits” into their optimistic view of our economy. I have reported in the past that several of the “worker bees” at the Fed continue to warn the big guys that true inflation is worse than what is being reported. But the FOMC members have let the U.S. economy back them into a corner, with the housing slowdown tying their inflation fighting hands. But the Fed doesn’t want us to know that they are unable to respond. So they continue to try and convince us that everything is “just right” with the economy; and that we are on a slow growth, stable inflation path. You and I know they are in denial, and this economy is far from being on the right path.

A more prudent central bank to our north is taking a more aggressive approach in their fight against inflation. The Bank of Canada raised its benchmark interest rate for the first time in more than a year and said a “modest” tightening may still be needed to slow inflation. Governor Dodge was urged by exporters and unions to delay the increase, but he held firm in his decision as commodity prices continue to move prices up in Canada.

Speaking of commodity prices, I’m sure everyone has noticed the tremendous move up in the price of oil over the past few trading days. Brent crude oil for August settlement rose to $76.40 a barrel in London, the highest close since August 9 of last year. The record price was set on August 7 of last year at $78.64. So oil is trading near record highs and shows no signs of moving back down with rising demand and continuing geo-political threats. And the increase in oil prices has also spilled over to alternative fuel prices including coal, and uranium.

So which currencies benefit from these higher energy prices? All four of the currencies that make up our WorldEnergy Index CD! Australia is a major supplier of coal and uranium to the Asian economies. The British and Norwegians have their North Sea oil, and Canada exports oil, coal and uranium to both the U.S. and China. All four of these currencies will continue to benefit from higher energy prices making this newest addition to our index CDs a good choice for investors.

A quick look at currency returns over the first half of 2007 illustrates how important commodity exports have been in determining the performance of the different currencies. Four of the top five performing currencies are those which are in either our Commodity Index CD or our WorldEnergy Index CD. After the Icelandic krona (up 17.22%), the New Zealand dollar (up 10.37%), Canadian dollar (up 10.14%), Australian dollar (up 9.28%), and Norwegian krone (up 7.61%) are the top returning currencies so far this year.

The Japanese yen gained for a second day against the dollar after a fall in U.S. stocks prompted speculation that investors will unwind “carry trades”. The Bank of Japan is widely expected to keep interest rates unchanged this week, but will likely move in August. As readers know, we think they should raise rates now and continue to raise them until they are back to a more “normal” level. But Japanese policy makers have been afraid of the consequences of raising rates and therefore have held off. This delay is simply going to make the adjustment of the Japanese yen much more dramatic when they eventually bite the bullet and go ahead with the increase. Japan’s wholesale inflation accelerated in June showing that the economy is now strong enough to withstand a rate increase.

The Chinese renminbi had the biggest two-day gain since a link to the dollar was dropped in 2005. The increase is an attempt by the Chinese central bank to show that the exchange rate is responding to the record trade surplus. As I reported yesterday, China’s trade gap widened 87% in June from a year ago, to $26.9 billion. U.S. Treasury Secretary Henry Paulson has “pussyfooted” on the issue of the renminbi, which hasn’t “risen fast enough,” Senator Charles Grassley said in an interview in Washington. Grassley is one of the three senators who proposed legislation for steeper anti-dumping duties to counter the benefit of undervalued currencies.

China’s economy could certainly withstand an increase in the value of the renminbi. The Chinese economy expanded 11.1% in 2006, more than the 10.7% growth initially estimated by the government. The new pace of expansion is the fastest in 12 years. China’s export driven economy is drawing closer to replacing Germany as the world’s third largest, as trade booms. GDP climbed 11.1% in the first quarter of this year and economists expect a 10.9% expansion in the second quarter. China’s economic engine continues to hit on all cylinders; good news for all of the commodity exporting countries who feed this massive country.

Currencies today: A$ .8611, kiwi .7764, C$ .9488, euro 1.3759, sterling 2.0308, Swiss .8318, ISK 60.54, rand 7.048, krone 5.7945, SEK 6.6644, forint 179.46, zloty 2.7469, koruna 20.6945, yen 121.55, sing 1.5152, HKD 7.8166, INR 40.376, China 7.5631, pesos 10.8535, dollar index 80.808, Silver $12.97, and Gold… $665.38

That’s it for today… Sure could use a Starbucks this morning, but no more wired Wednesday’s for me. We do get our favorite Chinese food for lunch today though. We’ve had a couple of busy days on the desk as investors continue to move money back into the currency markets. Back to work now, hope everyone has a great hump day!!

Chuck Butler — July 11, 2007

The Daily Reckoning