Euros - The New Reserve Currency

Good day… A slow data day yesterday got even slower when the Conference Board who was scheduled to release the leading indicators announced that the report would be postponed until this morning due to “database and technical issues”. Without any new data in the United States, traders focused their attention on the latest of a series of speeches given by members of the Federal Reserve Board.

Federal Reserve Bank of San Francisco president Janet Yellen continued to ring the inflation-warning bell as she warned, “a strong job market poses a serious risk of faster inflation.” Yellen, who spoke in Nevada, doesn’t have a vote on Fed Policy at the next rate setting meeting January 30 and 31. In the past week, we have had half a dozen public appearances by Fed policy makers who all seem to be singing from the same sheet of music. The Fed members have showed confidence that the economy will weather the housing slump and have showed little indication of relaxing concern over inflation. While the markets had previously priced a rate cut into the picture for 2007, it now looks like U.S. rates are likely to remain stable with a possibility of another increase sometime in 2008.

The U.S. currency rose after Yellen’s speech, but this dollar strength was reversed in European trading after positive reports were released in both the European Union and the United Kingdom. Reports from the European Union showed that French consumer spending and euro-region industrial orders rose more than economists had predicted. This data confirmed an earlier call by European Central Bank executive board member Lorenzo Bini Smaghi for further rate increases. “European growth will remain robust in 2007”, and with the inflation rate, “around 2%, a 3.5% interest rate is still accommodating,” Bini Smaghi said. ECB President Trichet signaled January 11 that investors are justified in expecting another increase in March.

In a move that should strengthen the euro even more, the European Commission has urged Italy and Germany to take advantage of the fastest economic growth in six years to reduce their deficits and debt. Italy, the euro region’s third-largest economy, will likely reduce its deficit as a percentage of GDP to below 3% this year. Germany, Europe’s largest economy, last year met EU budget rules for the first time since 2001. Keeping the members in line will certainly help to bolster the new focus on the euro as the world’s reserve currency. With the U.S. deficits and debt growing, strong economic fundamentals backing the euro will only accelerate the shift of reserves out of the U.S. dollar and into euros.

Ty Keough pointed out an article yesterday that appeared on with this headline, “OPEC Dumps $10.1 Billion of Treasuries as Oil Tumbles”. It looks like OPEC nations are unloading Treasuries at the fastest pace in more than three years as crude oil prices tumble. Over the last several years, the big oil exporting nations have purchased massive amounts of U.S. debt with the petrodollars they have earned from record high oil prices. As oil prices have sold off, these countries have reduced their holdings of U.S. treasuries. According to the Bloomberg article, for every $10 drop in the price of a barrel of oil, OPEC members adjust Treasury holdings by about $34 billion.

When you combine this reduction of available ‘petrodollars’ with Asia’s focus on diversification, it does not bode well for the U.S. dollar. Last year, the Asian monetary authorities, together with the central banks and state investment agencies in oil-exporting countries, bought about $770 billion in foreign-currency assets. These official purchases financed most of the estimated $870 billion U.S. currency account deficit in 2006, according to research by the Federal Reserve Bank of NY. If the petrodollar surpluses dwindle, the job of sustaining U.S. consumption will fall squarely on the Asian central banks, which have already stated a desire to reduce exposure to the U.S. markets. This is not shaping up to be good news for the U.S. dollar!

The U.K. pound sterling continued its assault on the $2.00 figure, trading over $1.99 for the first time since September 10, 1992. Reports released yesterday in the United Kingdom showed that house prices in January rose to a record, and a group of advisers forecast the fastest economic growth for this year since 2004. This data is likely to ensure continued support for the pound and increased expectations of monetary tightening.

In spite of all of this U.S. dollar weakness, the Japanese yen continues to stay above 120 yen per dollar, after last weeks BOJ policy decision to leave rates unchanged. Chuck pointed out the following which appeared on Stephen Roach’s Friday column posted on Morgan Stanley’s website 1/19/2007:

“In a stunning blow to central bank independence, the Bank of Japan seriously bumbled its January 18 policy decision. After setting up the markets for the second installment of a ‘normalization-focused’ monetary tightening, the BOJ buckled under political pressure and passed – electing, instead, to keep its policy rate unchanged at 0.25%. While this may end up being nothing more than a painful detour on the road to normalization, the incident speaks volumes about the Old Guard political dominance of Japan’s deeply entrenched LDP ruling party. It is a major credibility blow, with potentially lasting damage to the New-Economy image of a revitalized post-deflation Japanese economy.”

I couldn’t agree more. As readers know, the Japanese yen has been a currency that has tested our patience over the last year and a half. It is clearly one of the most undervalued of all the primary currencies, and the BOJ’s most recent moves continue to keep it that way. Their delay in raising interest rates just increases the pressure on the yen; and when it does start to move it will move in a big way.

And finally, I am going to end with a few comments Chuck sent me from down in Jacksonville. The Australian dollar continues to strengthen and remains one of the most popular currency choices of EverBank investors. Here are Chuck’s latest thoughts:

“Last week I wrote about how the Aussie dollar kept peeking through curtains at the, so far elusive, 80-cent mark. I believe this mark to be very important to the future performance of the Aussie dollar. For those of you keeping score at home, the Aussie dollar has had three attempts in the past three years at 80-cents… So obviously, this is quite a psychological mark. I believe the Aussie dollar will indeed push past this level this year.

“I remember working on the trading desk at the old Mark Twain Bank back in the mid-’90s…the ‘go-go days’ of the Aussie dollar. And with the report cards I’ve talked about for Australia… And the Reserve Bank of Australia coming back to the rate hike table… I say… Look out ‘go-go days’!”

Currencies today: A$ .7921, kiwi .7025, C$ .8443, euro 1.3026, sterling 1.9875, Swiss .8057, ISK 68.68, rand 7.09, krone 6.4157, SEK 6.986, forint 194.38, zloty 2.9612, koruna 21.41, yen 121.43, baht 35.91, sing 1.5349, HKD 7.7986, INR 44.23, China 7.7781, pesos 10.94, dollar index 84.65, Silver $13.10, and Gold… $637.70

That’s it for today… Chuck will be back home this evening so the Pfennig will be a little earlier tomorrow (no matter what time I get in, I never seem to be able to get it out as early as Chuck!) The currency markets seem to be moving in the right direction again. Hope everyone has a great Tuesday!!

Chuck Butler, January 23, 2007

The Daily Reckoning