Financial Storms Claim Two More

Good day… The financial storm claimed another victim this weekend as Lehman Brothers Holdings Inc. filed for bankruptcy after being unable to find a buyer. Bank of America, who was rumored to be bidding on Lehman, ended up buying Merrill Lynch & Co., and AIG Inc. is asking the fed for an emergency loan. All of this financial turmoil has sent the dollar lower versus most of the major currencies as investors are beginning to realize that the situation in the U.S. markets is worse than the rest of the world.

Over the past three months, currency traders have rallied the dollar on the basis that the United States was in better shape than Europe. They will now need to rethink their strategies, as the past few weekends show just how bad the U.S. financial sector is ailing. And unfortunately, there will likely be more to come. Risk aversion is a popular theme in the markets again, and the purchase of U.S. treasuries actually helped to keep the U.S. dollar from falling further.

The best performers over the weekend were the Japanese yen (JPY) and Swiss franc (CHF), both traditional funding currencies of the carry trade. As Chuck has explained several times in the past, when market volatility increases, traders typically start to exit the carry trades, which are only profitable during times of relative calm in the markets. The reversal of the carry trades means investors sell the emerging markets and high yield currencies and use the funds to pay down loans that they had taken out in the low yielding ‘funding’ currencies of Japanese yen and Swiss francs. The Japanese yen strengthened as much as 3.4% versus the U.S. dollar overnight, and the Swiss franc had the biggest one-day gain in six months.

I have to say, I am surprised Treasury Secretary Paulson stayed away from helping another bunch of his Wall Street buddies. I read where Paulson said Wall Street has been aware of Lehman’s troubles for a long time and had time to prepare for any crisis at the company. I know we closed out all of our currency trades with Lehman a couple of months ago, and hopefully most other prudent companies did the same. I hope this weekend’s events are an indication that some sanity has returned to the Treasury department, and a line has been drawn after the widest expansion of federal safety nets to the financial system since the Great Depression. It’s about time we quit guaranteeing the losses at these huge financial firms.

The big news over the weekend overshadowed the data released Friday that showed the drop in August’s U.S. retail sales was the largest of the year. The 0.3% decline in purchases followed a 0.5% drop in July. The figures signal that faltering consumer spending will keep inflation in check, adding strength to our argument that the Federal Reserve will likely resume lowering U.S. interest rates by year-end. Consumer weakness in the United States will extend the recession, which I believe we are already in, and force Bernanke to go back to easing rates here. Lower interest rates in the United States will put pressure on the dollar rally that has occurred over the past three months.

The other piece of data released on Friday here in the United States showed that producer prices fell in August for the first time this year. The dramatic drop in the price of oil was the main reason for the easing of producer inflation. Speaking of oil prices, crude continued to drop over the weekend falling back below $100 for the first time since the beginning of April. It should be interesting to see how this continued drop in crude will impact the dollar. Recently, the dollar and oil have had a negative correlation, with a surge in oil prices corresponding with a drop in the dollar, and the opposite occurring over the past few months.

The euro (EUR) hit a high of 1.4481 in early European trading before moving back down below 1.42. European Central Bank Vice President Lucas Papademos gave a shot in the arm to the euro over the weekend when he signaled that the ECB has little intention of pursuing U.S. style tax and interest rate cuts to support the European economy. “There are indications that broad-based second-round effects are materializing and we want to make sure that they don’t become even stronger and broader,” Papademos told reporters in Hamburg. “It’s not considered likely” that the euro area economy will shrink in the third quarter, he added. His comments were echoed by ECB council member, Yves Mersch, who said that slower economic growth and a drop in oil prices have not blunted inflation risks. The ECB will continue to battle inflation, and will likely react with another rate increase if benchmark inflation remains above their goal of 2%. This difference in the predicted paths of interest rates could be the factor that finally reverses the dramatic rebound in the dollar.

The Australian (AUD) and New Zealand dollars (NZD) fell as investors exited the carry trades. Both currencies continue to drop, as investors move away from the higher yielding currencies and back into ‘safer’ assets. The fall in commodity prices, a lowering of interest rates, and this reversal of carry trade investments have combined to move the kiwi 12% lower versus the U.S. dollar over the past three months. During the same time period, the Australian dollar has fallen almost 14% versus the U.S. dollar. The only good news for the Australian dollar lately has been the three-day rally in the price of gold, a major export for Australia. If Australia can refrain from further drops in interest rates and gold continues to rally, we could see the Aussie dollar make up some of the losses we have seen recently.

Should be an interesting day today in the currency markets, as investors digest this weekend’s events. In prior crises, after the initial sell-off in the dollar, the dollar actually rallied back up as investors moved into cash and the ‘safe haven’ of U.S. Treasuries. But a major sell off in the U.S. stock market could further losses in the dollar as foreign investors may finally decide they have had enough of the rollercoaster ride of the U.S. investments. But with most of the world’s economies slowing, investors are going to have to search hard for places to invest.

We continue to suggest investments into the Asian currencies and economies. While all of the global economy is expected to slow, Asia will continue to be the world’s growth engine. And with a burgeoning middle class in India and China, internal demand will make up some of the demand lost to recessions in the United States and possibly Europe. The Chinese renminbi (CNY), Singapore dollar (SGD), and Japanese yen should continue to be some of the best performers going forward. I also think some of the economies with strong underlying economic fundamentals will again become popular. These include the Swiss franc, Swedish krona (SEK), and Norwegian krone (NOK) all of which look cheap at their current levels.

Investors who have been waiting for a signal to purchase may want to start putting some of the U.S. dollar sitting on the sidelines back to work. As it becomes more and more apparent that the United States will need to lower rates again before increasing them, the dollar will get back on its long-term downward spiral. This weekend’s events could be the catalyst that finally ends this dollar rally.

Currencies today 9/15/08: A$ .8047, kiwi .6551, C$ .9324, euro 1.4185, sterling 1.7899, Swiss .8936, ISK 91.64, rand 8.2046, krone 5.7726, SEK 6.7497, forint 169.91, zloty 2.3749, koruna 17.075, yen 105.33, baht 34.57, sing 1.4340, HKD 7.7926, INR 45.935, China 6.844, pesos 10.7113, BRL 1.7810, dollar index 78.966, Oil $96.58, Silver $10.86, and Gold… $775.02

That’s it for today… St Louis got the remnants of Ike yesterday, with tropical storm type winds and rains rolling through the area. I actually ran with my wife in a half-marathon during the height of the storm. Almost 5,000 similarly crazy runners toughed out the heavy rain and strong winds, but the race had to be ended at 10 miles due to flooding on the racecourse. We were pretty upset, as my wife was running a personal best up until they shut us down. I feel sorry for all of the people down in Texas who are still without power; the winds also knocked out the power in some homes here. Hope everyone has a Marvelous Monday, and a great start to your week!

Chris Gaffney
September 15, 2008