Investors Move to U.S. Cash

Good day… The dollar made a strong move up overnight in Asian and European trading. I have spent most of the morning reading everything I could find to try and figure out the reason for this sudden move up, but I can’t find any good explanations. Lots of stories give the credit to this latest dollar rally to a reversal of the “carry trade”. But if the carry trade were truly reversing, we would see a dramatic move up in the yen (JPY) and Swiss franc (CHF), the two most common funding currencies of this trade. But both the yen and the franc have dropped versus the dollar (albeit less than others) and they have not moved up, so I don’t buy this argument.

Another more plausible explanation centers on the U.S. bond market and the emergence, again, of a positive yield curve. The long-term bond yields in the United States have finally moved above 5% with the 30-year bond now yielding close to 5.30%. The theory is that investors, seeing yields rising in the United States, are selling off risky assets (namely emerging market equities) and bringing money back into dollar. The rising bond yields are a prediction of global inflation, which will be negative for stock markets.

Those markets, which have had the biggest gains, are also some of the riskiest. With rising global inflation, investors are selling these equities and are moving back into cash. The dollar is still seen by the world’s investors as the safest place to park cash. With global equity markets moving down, I believe this is the most likely explanation for our sudden rally in the dollar.

So where does it go from here? As I said above, the world’s investors are currently flocking to cash. Eventually this cash will need to be put back to work, or will be used to pay off the loans which many of these investors have used to create the explosion of liquidity we have seen over the past few years.

As I have said in the past, many loans are denominated in the lowest yielding currencies, the Japanese yen and the Swiss franc. If/when investors finally decide to pay back these loans, they will need to buy both of these currencies and the carry trade will be reversed. As I mentioned above, I think blaming a reversal of the carry trade for the move in currencies overnight just doesn’t make sense. But, at the same time, I do believe we have seen the first step in a reversal of this trade.

Whenever I talk about the carry trade I always get several emails asking me to explain it. For the long-term readers, just skip over this paragraph as you have read this explanation several times before. The carry trade is when investors borrow at the lowest yield and then invest in higher yielding assets. Currently the lowest yields are found in Japan, and Switzerland along with some other Asian nations. So investors have borrowed yen and Swiss francs, which they have sold in order to invest into higher yielding assets. Usually, when we talk about the carry trade we mention investments into the highest yielding currencies, the Icelandic krona (ISK) and the New Zealand dollar (NZD). But much of these borrowed funds have been invested into emerging market equities.

The sell off in the Asian markets last week has been followed up with more selling in other equity markets. Carry trade investors haven’t yet given up on the trade, and right now they are parking their cash in the U.S. dollar, waiting to see what happens. After all, with short-term U.S. treasury rates just over 5%, they can hold dollars in cash, and still make a small spread since interest rates in Japan are at or below 1%. But there are costs associated with these loans, and with interest rates slowly creeping up in both Japan and Switzerland I don’t think they will sit on U.S. cash for very long. These investors are either going to have to repay the loans, buying back the yen and Swiss francs, or they will move this cash back into higher yielding markets.

So this latest move by the dollar is just temporary. Investors are using the dollar as a parking spot while they are waiting to see where to invest next. Europe and Asia continue to grow at a better pace than the United States, so I believe investors will be returning to these markets. The higher long-term rates here in the United States will make all of the adjustments on mortgages impact U.S. consumers even more. A slumping housing market and rising interest rates will continue to make U.S. consumers tighten their spending. The dollar will continue to trend down versus the currencies of economies that are better off.

As investors move away from riskier assets, the countries with strong balance sheets will begin to trade at a premium. These include the Nordic currencies of Norway and Sweden. I also think the commodity countries will continue to perform well, including the Canadian dollar (CAD) and Australian dollar (AUD). So investors looking to take advantage of this most recent dollar strength can look to a few of our index CDs, which combine some of these stronger currencies. Our latest index, the WorldEnergy CD combines a couple of these currencies and has been a big hit with investors. I also still like the Euro Trax Index CD, which combines Norway, Sweden, Euros and Swiss.

The Canadian dollar may see some buying today as the Canadian jobless rate stayed at a 33-year low in May. Canada’s economy seems to be near full capacity so the Bank of Canada will likely be forced into raising interest rates again this year. The BOC said last month that there was “excess demand” in the economy and signaled that policy makers may raise their benchmark interest rate July 10 to curb inflation. Low unemployment, record consumer spending, and rising energy and housing costs have boosted inflation forcing the BOC to move rates up. This should be positive for the loonie.

Traders are already questioning the non-move by the Bank of England earlier this week. U.K. factory production increased for a second month in April, and has expanded 1.3% on the year. An economist at BNP Paribas in London said it best in an interview last night: “Inflation is high and sticky. Underlying prices will continue to accelerate throughout this year. The BOE is behind the curve.” As Chuck said earlier this month, the BOE needs to aggressively raise rates to combat this growing inflation. The continued upward pressure on rates will keep the pound sterling (GBP) well bid.

Gold fell again in London and is heading for the biggest weekly drop in three months. Apparently gold fell victim to the same equity selling that impacted the currency markets. As I mentioned above, much of the money invested into the equity markets has been leveraged. With the long sell off in these equity markets, investors have been forced to sell gold to fund their margin calls. But declines will likely be limited as physical buyers take advantage of the falling prices. India, the world’s largest buyer of gold, has increased its purchases of gold over the past few days.

This morning we will see the U.S. trade deficit, which will likely show a decrease for April. While the gap may in fact narrow, the sheer size will continue to exert downward pressure on the U.S. dollar. The trade deficit is expected to fall to $63.5 billion from March’s deficit of $63.9 billion. Anything above $63 billion is negative for the dollar.

Currencies today: A$ .8392, kiwi .7500, C$ .9353, euro 1.3339, sterling 1.9645, Swiss .8107, ISK 64.62, rand 7.34, krone 6.074, SEK 7.0032, forint 191.37, zloty 2.8875, koruna 21.31, yen 121.56, sing 1.5424, HKD 7.8151, INR 41.14, China 7.6670, pesos 11.0245, dollar index 82.84, Silver $13.30, and Gold… $654.85

That’s it for today… Just wanted to share some parting thoughts after what has been a crazy week here in the WorldMarkets. I was relaxing last night and began to reflect on just how fast the world is moving. A few unfortunate minutes last week changed our family’s summer plans; but thanks to modern medicine my daughter is just fine and is even able to swim (she got a new swim cast yesterday!) This weekend I would encourage everyone to take a few minutes to stop and smell the roses. Life can change in an instant, so enjoy every day to the fullest! Hope everyone has a terrific weekend!

Chuck Butler — June 08, 2007

The Daily Reckoning