Interest Rate Differentials Dominate Trading

Good day… The dollar slid throughout Monday to close near record lows versus the euro (EUR) and pound sterling (GBP) as interest rate differentials dominated the attention of currency traders. This dollar slide occurred despite positive news regarding the U.S. economy. The ISM manufacturing index rose to 56 in June from 55 in May, the fastest pace in 14 months. While manufacturing data was surprisingly strong, many attribute this strength to an increase in stockpiles after companies trimmed inventories during the first quarter.

Data released this morning is expected to show factory orders fell by 1.2% in May. This data will be in direct contrast to the ISM manufacturing data, which showed an unexpected increase yesterday. Perhaps this is why the currency traders seemed to ignore the ISM data and instead focused on interest rate differentials. The dollar slide is likely to continue today, as the data will be negative and the markets will be closing at noon for the July 4th holiday.

As I reported in the opening paragraph, the dollar traded near a record low against the euro and the weakest in 26 years versus the British pound. The driving force in the currency markets right now is interest rate differentials. Many of you long term readers will remember Chuck’s acronym for this trading pattern, SIRT (Stupid Interest Rate Talk & Trades). This SIRT was one of the major reasons the dollar gained during 2005 and the beginning of 2006. At that time, the United States was raising rates and Europe was keeping their rates steady. Now the shoe is on the other foot, and SIRT is beginning to work against the greenback.

Investors are favoring currencies where they believe interest rates will rise. The Bank of England and the ECB both will likely announce rate increases later this week, and currency traders are buying these currencies in front of these rate decisions. The European economies continue to expand, and unemployment fell to a record in May as companies added jobs to meet this strengthening demand. According to reports released this morning, the jobless rate in the euro area declined for a seventh month, and producer prices rose in May. These data support our thoughts of further rate increases by the ECB and BOE. With our FOMC’s hands tied by the subprime mortgage meltdown, interest rate differentials will continue to exert downward pressure on the dollar.

Even the Japanese yen (JPY) seems to be benefiting from the FOMC’s stable rate policy. The yield differential between Japanese and U.S. debt is diminishing. The yield premium investors earn on benchmark two-year bonds over similar maturity Japanese debt was near a seven-week low today and will likely continue to shrink. The Bank of Japan is now widely expected to increase interest rates in August, and while it will take a number of aggressive moves before Japanese interest rates are even close to U.S. rates, the risk of a sudden move up by the yen has investors spooked.

And they should be. According to the Futures Trading Commission, speculators including hedge funds held near record numbers of futures contracts betting on yen losses. Volatility in the currency markets has been creeping higher, and this volatility is priced into option contracts. With volatility, and therefore option prices increasing, and the interest rate differentials likely to narrow, the carry trades are becoming more expensive and less profitable.

I sometimes feel like Chicken Little regarding the Japanese yen and carry trade reversals. I have written at length about the massive short positions and the global imbalances that have built up as a result of the undervalued yen. But I continue to believe patient investors will see some dramatic moves in the yen. At some point, the stars will align and investors will begin to exit these short positions. As the yen moves up, more short positions will need to be unwound, and so on, and so on. But the question remains, when will the move begin?

In addition to hitting fresh 26-year lows against sterling and fresh two-month lows against the euro (and half a cent away from its all time low), the dollar hit all time lows against the Aussie (AUD), 25-year lows against the New Zealand dollar (NZD), and is nearing its 30-year lows against the Canadian dollar (CAD). Sounds like our Commodity Index CD is going to have a great quarter! This index combines the Aussie dollar, kiwi, Canadian dollar, and South African Rand (ZAR) and has been one of our most consistent performers.

Our newest index is also doing well. The World Energy Index CD combines the Australian dollar, Canadian dollar, pound sterling, and Norwegian krone. The introduction of this index couldn’t have been better as all four of these currencies have been moving up nicely over the last four months. But it still isn’t too late to invest. Global economic growth will continue, powered by Asian manufacturing. These four countries supply much of the raw materials that feed this economic engine. I really don’t think you can go wrong with either the Commodity Index or our new WorldEnergy Index CD. What a great way to get some currency diversification in your portfolios!

Australia’s central bank board met today and probably decided to keep interest rates unchanged. Reserve Bank of Australia Governor Glenn Stevens will announce the board’s decision tomorrow in Sydney. Stevens, in his first public comments since February, said last month the bank has “additional time” to respond to a pickup in economic growth and a jobs boom after consumer prices rose less than expected in the first quarter. Figures released today showed that retail sales unexpectedly fell in May and that building approvals slumped to a six-year low. While this data supports a non-move decision by the RBA, the currency markets still believe interest rates will be higher by this time next year. These interest rate expectations, along with an excellent export market for commodities will have the Aussie dollar setting new record highs versus the U.S. dollar.

The recent sell off in the dollar has helped gold rise over 3% in just three days. Gold is being purchased as an alternative to the dollar, and recent terror threats have seen safe haven flows into precious metals. We continue to offer both gold and silver investments through our Metal Select program, and will soon introduce a brand new way to invest into silver (a little hint, it will be very similar to our popular Gold MarketSafe CD!). Stay tuned, as I’m not supposed to start talking about it just yet.

Currencies today: A$ .8556, kiwi .7829, C$ .9450, euro 1.3602, sterling 2.0152, Swiss .8216, ISK 62.09, rand 6.9821, krone 5.8335, SEK 6.7874, forint 180.74, zloty 2.7615, koruna 21.153, yen 122.49, sing 1.5239, HKD 7.8135, INR 40.55, China 7.5940, pesos 10.755, (no dollar index quote), Silver $12.67, and Gold… $657.80

That’s it for today… I checked one last time for updates on Jennifer’s baby, but nothing new to report. I’m sure I will be able to give you all the details tomorrow. Had a great Lobster at Legal Seafood last night, and we are heading down to the Boston Aquarium this morning with a trip over to Cambridge this afternoon. Short trading day back on the desk, as the markets will close up at noon. Hope everyone has a great Tuesday, and Happy 4th of July!!!

Chuck Butler — July 03, 2007

The Daily Reckoning