Get ready for a Volatile Week in the Markets

Chuck is getting on a plane bound for Mexico this morning, so I will be bringing you the Pfennig this week. As usual, Chuck left me a note to share with all the readers last night, so heeerrreee’s Chuck:

On Friday, we saw more healing in the currencies and metals, from the price action earlier in the week. Gold jumped up $15, and I have to think that some of that gain came from the heightened risk from the packages from Yemen. I tell you all the time that we have a ton of nut-jobs running around the world, wanting to blow this up, or wipe this country off the map… But gold – with silver tagging along – will always be sought when geopolitical risks elevate.

So… Welcome to November. I used to complain about November a lot, but the past couple of Novembers haven’t been that bad, so I’ll wait to complain. HA! This first week of November is going to be quite full of risks. With the FOMC meeting tomorrow, the pending announcement of QE2, and the Jobs Jamboree on Friday. I’ve already beaten the thoughts for QE2 to death, so I’ll let Chris take it from here!

Thanks again to Chuck for leaving me a little something to get the words flowing. As Chuck suggests, you all better fasten your seat belts, because this week is looking like it could be a doozy. I was paging through some research last night preparing for this morning and I couldn’t help but get a bit worried about what the week will bring for the currency markets. The US elections, followed by announcements by all of the major central banks could form a “perfect storm” in the currency markets with volatility pushing the dollar to extremes.

The week will start off fairly quiet as we will get Personal Income and Spending information for the US later this morning. Both income and spending is predicted to have risen a bit in September, with spending rising faster than incomes (no real surprise there!). We will also see the ISM Manufacturing data which will likely show a small decrease in US manufacturing activity last month. These data releases also include inflationary estimates, and both the PCE Deflator and ISM Prices Paid numbers are expected to show that no inflationary pressures exist in the US markets. This is important, as Bernanke and his buddies need to be able to point to the inflation data to assure the markets that the US economy can handle another round of QE. As long as the data continue to show that inflation is being held back, the FOMC will likely push more liquidity into the markets.

As Chuck pointed out in the opening paragraphs, the markets are pretty much ignoring tomorrow’s US elections, and are instead focusing on the FOMC’s announcement, which should be released Wednesday afternoon. I for one can’t wait to get these elections over with, as I have had enough of the negative ads and intrusive phone calls from both political parties each evening. It will be interesting to see just how many incumbents get the boot tomorrow. But it seems the markets either don’t really care who is in charge of the House and Senate or maybe they realize that it doesn’t really matter who has the helm of a rudderless boat! The debt burden that the US has accumulated is pushing us down a scary path, and our elected officials have little control over the direction we are heading. But we have to continue to try and take back control of this economy, and tomorrow’s elections may be a start. Currency traders are looking past the elections and focusing on the 33 hours following during which all of the major central banks will be making rate announcements.

Central banks are locked in a “race to the bottom” for their currencies, as both the Federal Reserve and Bank of Japan are expected to announce further measures to keep borrowing costs low in order to spur growth. With interest rates already as low as they can get them, both central banks are looking to perform another round of quantitative easing by purchasing debt, pumping fresh cash into the markets. With all of the QE talk pushing the dollar and yen (JPY) lower, European central banks are working to make sure their currencies don’t appreciate too quickly. The ECB is reminding the markets that the European sovereign debt crisis is still hanging around, an obvious attempt at “jawboning” intervention. Recoveries in the major global economies have largely been based on exports, so these central bankers want to try and keep the value of their currencies down in order to keep exports up. But the currency markets are a “zero sum” game, and while many believe all fiat currencies will eventually fall to their intrinsic value (the value of the paper they are printed on) for now if one currency is falling, another has to rise.

The race to the bottom by the US, Japan, and the ECB is benefiting the emerging markets and any country that is not looking to lower rates. In Europe, we have seen recent gains in the pound sterling (GBP), which is trading at the highest level in 9 months versus the US dollar. This strength comes on the back of data showing a jump in GDP and UK manufacturing growth. This recent strength has currency traders speculating that the Bank of England will refrain from joining the BOJ and FOMC in a new round of QE.

Chinese manufacturing data showed the fastest pace of appreciation in six months during the month of October. This data suggests the Chinese economy will continue to expand in spite of the recent interest rate increases and gains in the renminbi (CNY). The good news for the Chinese economy was great news for the emerging market currencies as a strong Chinese economy is predicted to keep demand high for the commodities which many of these emerging markets are rich in. The currencies of both Australia (AUD) and New Zealand (NZD) also benefited from the positive reports out of China. The Aussie dollar got within one cent of parity with the US dollar, and the kiwi hit a two-year high. Interest rates and strong commodity prices continue to be a strong wind at the back of these currencies.

The Reserve Bank of Australia will be looking at rising employment and increasing inflation risks during their meeting tomorrow. The recent inflation data has convinced most of the economists that the RBA will leave rates unchanged. But there is still a chance they move rates up, and further rate increases are all but certain in the coming months. Investors will continue to move funds into Australia and New Zealand in order to take advantage of very nice interest rate differentials. Japanese investors have been finding these yields particularly attractive, and have formed a good base for both of these currencies. With US yields looking to stay low, and the global economic expansion continuing to gain a bit of steam, the Aussie dollar and New Zealand kiwi will continue to present some attractive investment opportunities.

The current global economic situation is really two very different stories: while the US is staring at the possibility of deflation, Asian markets are starting to have to deal with inflationary pressures. Both China and India have been moving their interest rates higher, in direct contradiction to what is happening in the West. While China has grabbed a majority of the spotlight in Asia, India has also been growing at a tremendous pace. India is poised to join China, Japan, and Taiwan as countries with over $300 billion in reserves. These higher reserves have pushed the value of the rupee (INR) up, with the largest two-month gain in over a year. The rupee still hasn’t matched the gains of the Japanese yen and Singapore dollar (SGD) this year, so the recent moves could prove to be just the beginning of a sustained period of strength for the Indian currency.

And finally, the US isn’t the only country that will be getting the results of national elections this week. Brazil’s presidential election campaign ended yesterday with Dilma Rouseff securing the Presidential office. Ms. Rouseff was heavily favored, and was the choice of outgoing President Luiz Inacio Lula da Silva. She is expected to continue the policies of the outgoing president, which will be good news for the long-term prospects of the Brazilian real (BRL). Mr. Lula da Silva has kept interest rates high in order to control inflation, and has been successful in reducing government debt. Strong Chinese demand for commodities and a very large interest rate differential with the US should keep the Brazilian real as one of the best performing currencies in the coming year.

To recap, Chuck picked a doozy of a week to be away from the desk, as the US elections and central bank announcements promise to increase volatility in the currency markets. The US, Japan, and ECB all look to try and keep their currencies down in order to stimulate their economies. Chinese data showed a large pick up boosting demand for commodity-based currencies. The RBA will likely keep rates unchanged, but there is still the possibility of an increase, and Brazil elects a new President.

Chris Gaffney
for The Daily Reckoning