Investor Confidence Unwinds Carry Trades
The currency markets fell back into their established routine also, as fear drove investors out of riskier assets and back into the U.S. dollar. We saw a general reversal of the carry trade, with the Japanese yen (JPY) the only major currency which appreciated versus the U.S. dollar. As Chuck pointed out last week, investors feeling more confident about the global economy, dusted off their carry trades which had made them good money over the past few years. But traders are still a bit skittish, and move back out of these leveraged trades at the first sign of trouble in the global economy.
Europe delivered the bad news overnight with the released of first quarter GDP in the 16-member euro region. Gross domestic product fell 2.5% from the fourth quarter, when it fell 1.6% according to this morning’s report. This is the biggest drop since euro-area GDP data was first compiled in 1995, and was 50 basis points higher than the 2% drop expected by most economists. Inflation data was also released for the euro-region this morning, and showed prices are holding steady.
The fall in GDP will likely renew calls for Trichet and the ECB to step up ‘quantitative easing’ in order to stimulate the European economies. But I have to believe that the ECB got ahold of a ‘preliminary’ copy of this data, and had a pretty good idea of the bad news prior to their meeting last week. Unemployment in the euro region continues to climb, and the flat inflation data will strengthen the argument for a more aggressive move by the central bank. While the ECB did leave themselves room to increase the money supply, they seem to be content to wait it out a bit before becoming too aggressive with monetary easing.
Since I have been away from the desk for most of the week, the first thing I did this morning was turn on the screens to catch up on what data we were going to get today. It was a bit of a shock, as the list of reports filled the screen. Inflation data will be first up this morning, with the release of the April CPI numbers here in the US. Inflation is expected to show no change for the month of April, with only a small 1.8% increase in the core CPI compared to last year.
The inflation numbers will be followed by the Empire manufacturing number, which everyone expects to show another major contraction in manufacturing here in the US. Then we will get the all-important TIC flow data, which will give us an indication of the appetite of foreign investors for our US treasuries. We have educated investors on the importance of this number for years, as foreign investment is the only thing enabling the US to continue to live above our means. With the large increase in the budget deficit predicted for 2009, foreign investment has become even more important. But several overseas investors, including Asian central banks, have started worrying about the amount of US debt they are holding. But even if they wanted to continue financing our debt (and they have many self-serving reasons to do just that), the drop in global trade has put less money in the coffers of these export driven economies. They simply don’t have as much to invest as they did during the past few years.
So I would expect to see the TIC flows decrease, putting Bernanke and his boys in an even tougher spot. There are two ways they can try to entice these foreign investors back into the US treasury market, either let interest rates increase, or let the value of the U.S. dollar fall. Now which do you think they will choose? They have been running the printing presses on overdrive in order to try and keep interest rates down to create another refinance boom. The Fed will try to do everything they can to keep interest rates down, so the alternative is to let the value of the U.S. dollar fall. The drop in TIC flows, combined with a huge increase in funding requirements by the US, will have to lead to a general debasing of the US dollar.
To close out the morning, we will get Industrial Production and Capacity Utilization for the month of April, and the U. of Michigan confidence number. Industrial production is expected to have declined again, but the rate of the drop is slowing. Output is expected to fall .6% during the month of April, after falling 1.5% during March. If these numbers come in as expected, the US media will undoubtedly spin it as a positive sign that the US economy is bottoming.
With the carry trade reversing, both the New Zealand (NZD) and Australian dollar (AUD) fell, posting their first weekly loss since February. Both these currencies have benefitted from a move back into riskier assets, which is now beginning to be reversed. New Zealand’s kiwi also fell due to a report which showed retail sales dropped in the first quarter almost twice as fast as economists predicted. But the main driver of the sell off in both the kiwi and Aussie dollar has been the reversal of investor sentiment, and the move back out of the carry trade positions.
The Australian dollar, which is coming off a pretty big drop last year vs. the greenback, is now predicted to be one of the best performers during the global recovery. As China’s economic engine revs up again, commodity prices will move back up supporting the Aussie dollar. China’s infrastructure spending has already boosted the prices of base metals which has helped to fuel a rally in the price of the Australian dollar. Mellon Capital Management Corp. released a report yesterday, which stated the Aussie dollar would rally the fastest among the world’s major currencies. The report cites China’s $585 billion economic stimulus plan to improve housing, highways, airports, and power grids. The Aussie dollar has advanced 12% against the dollar since China announced the stimulus plan on November 9th. The Aussie dollar should continue to appreciate, so any sell off due to carry trade reversals should be viewed as a great opportunity to add to positions.
Another commodity-based currency that we have been watching is the Norwegian Kroner (NOK), which is the fourth best performing currency vs. the U.S. dollar in 2009 (The top is the Brazilian real (BRL), followed by the South African rand (ZAR) and then the Australian dollar). Norway’s government announced it would raise spending and add to the stimulus package it announced earlier. Norway will spend an extra 9.5 billion kroner ($1.5 billion) to create jobs. The Norwegian mainland economy (ex oil, gas, and shipping) is predicted to contract 1% this year. But if we continue to see positive signs out of China, oil and shipping revenues should rebound, and Norway could very well post a positive GDP for 2009. I continue to feel the Norwegian kroner is one of the best investments for diversification out of the U.S. dollar.