Inflation Creeps Back

Good day… And what a good day we had in the currency markets yesterday. The U.S. dollar shook off data which should have sent it up, and instead moved back down wiping out the dollar gains we saw late last week. Today will be a slow data day here in the United States, with the MBA Mortgage applications being the only piece of data released. I look for the currencies to continue the trend they started on Monday, closing out today slightly higher than where they are now.

As I said above, the data released in the United States yesterday morning were largely dollar positive. Producer prices jumped by the most since 1974 moving up 2% compared to last months decrease of 1.6%. The YOY Ex Food & Energy or Core number also showed an increase coming in at 1.8% compared to last months 0.6% increase. This data will give the FOMC confidence that their decision to keep rates unchanged over the past few months was a good one. With inflation slowly creeping back up, calls for a rate cut in early 2007 will be muted.

Housing starts for the month of November increased slightly while building permits showed a slight decline. This morning we saw the release of the MBA Mortgage applications, which fell a surprising 10.2% compared to last week’s increase of 11.4%. This mixed data on the housing market will perpetuate the discussion between those that believe the worst is over, and others who think the housing bubble is just starting to deflate. I am in the latter crowd, and expect housing to continue to be a drag on the U.S. economy during 2007.

European central bank president Trichet gave the euro some support today while addressing the European Parliament’s economic committee in Brussels. Trichet said the economy of the dozed euro nations remains at risk of accelerating inflation, signaling he’ll probably endorse interest rate increases next year. The ECB is known for being hawkish on inflation, and Trichet’s words will continue to provide support for the euro. “Acting in a firm and timely manner to ensure price stability in the medium term is warranted,” he said. “The governing council will therefore monitor very closely all developments so that risks to price stability over the medium term do not materialize.”

German business confidence unexpectedly surged in December to the highest level since reunification in 1990 after export growth fueled company hiring and investment. It is obvious that the economies of Europe and the United States are moving in opposite directions. This divergence will continue to cause the interest rate differential, which supported the U.S. dollar for all of 2005, to continue to narrow. The combination of a strong European economy and a narrowing interest rate differential will keep the euro well supported for the near future.

In other European news, the minutes from the Bank of England’s December sixth policy meeting were released this morning. The report showed the members voted 9-0 to keep the benchmark interest rate at a five-year high and cited concern that wages might pick up, pushing inflation higher. These minutes will give additional support to our call that the BOE will likely raise interest rates again next year after two, quarter point increases in four months.

Good news from New Zealand yesterday caused the kiwi to rebound to an 11 month high against the U.S. dollar. A report showed that the nation’s current account deficit shrank for the first time in three years. This report followed data showing a surge in consumer confidence, adding to speculation that the central bank may lift interest rates as soon as next month.

Consumer confidence had its biggest quarterly jump in almost six years. While this is excellent news for the kiwi, we still are looking at this currency with a cautious eye. The current account deficits remain over 9% of GDP, which is concerning. The kiwi has also seen a lot of buying as a result of the ‘carry trade’, which will likely start to unwind as the BOJ raises rates early next year.

Speaking of Japan, Prime Minister Abe’s first budget shows Japan may eliminate its budget deficit earlier than the target date of 2011. With a decreasing budget deficit and growth moving back into the economy, the BOJ is more likely to get more aggressive with rate increases during 2007. The Japanese yen continues to be one of the world’s most undervalued currencies. Investors need to continue to be patient here.

As I reported yesterday, the Thai government back-pedaled on their previously announced restrictions, lifting the restrictions on investments into their stock market. The restrictions remain on the currency forward markets, so we are still unable to offer the Thai as an investment option. The back-pedaling by the government has given a little support to the baht, as the currency has held steady at the 36 baht /US$ level.

Currencies today: A$ .7856, kiwi .6978, C$ .8702, euro 1.3216, sterling 1.9713, Swiss .8236, ISK 69.29, rand 7.00, krone 6.1761, SEK 6.809, forint 190.98, zloty 2.8788, koruna 20.78, yen 118.12, baht 35.82, sing 1.5388, HKD 7.7746, INR 44.74, China 7.8152, pesos 10.8153, dollar index 83.33, Silver $12.75, and Gold… $624.05

That’s it for today…MIZZOU lost a close one last night to the fighting ILLINI. Got to go now, as the phones have been busy with Thai baht holders calling in. Kristin is here with the Starbucks!! Hope everyone has a great Wired Wednesday.

Chris Gaffney
December 20, 2006

The Daily Reckoning