Housing Concerns Weigh On Consumer Confidence

Good day. Chuck was able to get trading done and scoot out of here just in time to catch the little jet, which begins his long journey to Stowe. I’ve never been, but Chuck tells me it is one of the most beautiful places to view the fall colors. Unfortunately, this trip will be a little early for watching the change of seasons! Today we will see if consumers have changed their view on the U.S. economy. With expensive gasoline and a free-falling housing market, the consumer confidence number is expected to fall to the lowest level of the year. The Conference Board’s index of confidence is expected to drop to 102.5 from 106.5 in July. Later in the day, we will get to see the minutes from the FOMC meeting of August 8, 2006, when rate increases were paused.

As Chuck mentioned yesterday, nothing much came from the annual mountain retreat this weekend in Jackson Hole.  None of the members of the FOMC who attended the event spoke about the current state of the economy or rates for the record. However, some of the economists who attended were able to speak freely, and most feel the central bank is caught between a housing slump that is just beginning and consumer-price increases that are too high for comfort.  The sharp reduction in both new and existing home sales reported last week will undoubtedly dampen the ability of consumers to continue using their homes as ATMs. With no data showing sharp increases in inflation, we expect the FOMC to keep rates stable at the September meeting – a move that should weigh on the U.S. dollar.

While confidence in the United States is expected to fall, German consumer confidence rose to the highest in almost five years. German households are stepping up spending to avoid higher sales tax next year, fueling economic growth. The German economy is on track for its best performance since 2000.

Inflation in the Euro region slowed for a second month in July according to reports released yesterday. M3, the ECB’s preferred measure of money supply (yes, the same number that our Fed says nobody pays attention to), advanced less than economists forecast, gaining 7.8% compared to 8.5% in June. But while M3 growth is slowing, it continues to stay above the 4.5% rate the ECB says risks fueling inflation.

Also, credit growth to households and companies matched the fastest pace since 1998.  These numbers aren’t strong enough to force a move by the ECB at their next meeting on Thursday, but I do expect ECB President Trichet to signal more rate increases are in the works. We expect a hawkish statement from Trichet on Thursday, signaling another rise in European rates for October and an additional increase at the end of the year. Interest rate differentials will continue to tighten, taking away the yield advantage, which has helped to prop up the U.S. dollar.

The U.K. economy continues to surprise economists, growing at the fastest pace in two years during the second quarter. Consumer spending rose at more than three times the rate of the previous three months and gross domestic product increased according to reports released yesterday. With strong consumer spending and domestic demand up, we expect the BOE to raise rates again before year’s end. The pound sterling, which has turned in one of the best year-to-date performances versus the U.S. dollar in 2006, should continue to do well.

Chuck’s mentioned the return of the “carry trade” yesterday generated several e-mails, so I will go over the details again. In carry trades, investors borrow in a currency with low rates and sell it to buy securities in countries with higher yields. The sales weaken the borrowed currency. With interest rates hovering around 0% and a very large banking system, the Japanese yen has been the favored currency to borrow for this trade. Earlier this year, traders abandoned the strategy as the Bank of Japan signaled it was preparing to raise borrowing costs for the first time in almost six years. These same investors flocked back to the carry trade this month after bank Governor Toshihiko Fukui pledged to keep increases “gradual” and an economic report showed that consumer prices were rising slower than expected. But this carry trade is fraught with danger as the fundamentals suggest the yen should be valued much higher than it is currently trading.

Pressure on the BOJ to raise rates got turned up a little last night after Japan’s unemployment rate fell and job vacancies climbed to the highest in 14 years. The jobless rate dropped to 4.1% in July from 4.2% a month earlier. As Chuck warned, it is not a question of if the BOJ will raise rates, but when. You better believe that all of the investors who have jumped back into the carry trade will reverse positions again as soon as they see the BOJ looking to raise rates. The positions built up during the past month will only cause the appreciation of the yen to be accelerated once it begins to move up.

Two of the higher yielding emerging-market currencies took dramatically different trading paths recently, as the South African rand dropped to the lowest in a month versus the U.S. dollar, while the Mexican peso had the biggest gain in six weeks. Bad news first: the South African rand continued to slide on concern metal exports will slow. The trade balance released today shows the seventh straight monthly deficit as gold, South Africa’s biggest export, has been selling off. Countries with current account deficits have lost favor, and traders now demand more of a risk premium. With interest rates barely above those offered by New Zealand and well below those in Iceland, investors are no longer paid enough premium to hold the rand.

Now, the good news from the emerging markets: Mexico’s peso had its biggest gain in six weeks after the federal election court rejected claims of irregularities in last month’s presidential election. The court’s decision puts the ruling party candidate, Felipe Calderon, who has pledged to keep spending and inflation in check, one ruling away from certification as the winner of the July 2nd vote. The court has until September 6, 2006, to declare a winner. Lopez Obrador continues to call for protests, and this gain in the peso could quickly reverse if these protests turn violent. The markets would prefer a Calderon victory as Obrador promised to boost spending to help the poor raising fears of inflation.  We would suggest remaining on the sidelines here until the unrest settles down. For speculation, we feel you are much better in Iceland, where you will be paid a much higher premium for your risk (which is still very high!).

Currencies today: A$ .7631, kiwi .6426, C$ .9017, euro 1.2815, sterling 1.8999, Swiss .8125, ISK 69.88, rand 7.1250, krone 6.2774, SEK 7.218, forint 215.09, zloty 3.08, koruna 22.011, yen 116.78, baht 37.53, sing 1.5735, INR 46.50, China 7.9622, pesos 10.85, dollar index 85.06, silver $12.12, and gold $616.52.

Look for the dollar to move down this morning after the release of consumer confidence, but be careful as any inflation concerns in the minutes of the FOMC meeting could quickly turn it around. Jennifer and Ty are both back this morning, so we will only be missing the big boss. Hope everyone has a great Tuesday!

Chris Gaffney
August 29, 2006