Leading Indicators Predict a Slip in U.S. Growth

Good day… The currency markets held steady yesterday as traders continued to digest Bernanke’s testimony and compared it to the minutes of the June 28 FOMC meeting which were released in the early afternoon. It seems everyone is trying to figure out what direction the Fed will take as our economy continues to drift toward a very scary scenario of very low growth (nearing recession) with rising inflation. Yesterday’s big data release was the leading indicators, a measure of the economy’s future direction, which fell more than forecast in June.

The Conference Board’s index of leading economic indicators declined 0.3% after rising a revised 0.2% in May. The reason given for the fall? The housing slump! Separately, the Fed of Philadelphia’s manufacturing index also fell last month. These figures suggest that the economy will slow in the second half of the year after probably growing about 3% last quarter. So where does that leave the Fed’s predictions of a second half recovery?

The only other data released yesterday showed that weekly jobless claims held above 300K and continuing claims crept up to over 2570K. The job market isn’t worsening, but it sure isn’t getting any better either. But according to the minutes of the FOMC meeting, the employment picture isn’t really concerning Bernanke. While he nibbled around the edges of the housing problem in his remarks yesterday and the day before, Fed policy makers still believe the United States will expand at a moderate pace in the second half of 2007. The currency markets don’t buy it, and the dollar continues to trend off.

I was over at Chuck’s last night and we had a good discussion about the U.S. economy and the currency markets. Chuck must have picked up his computer after I left and pounded out the following thoughts, which were waiting for me this morning:

“Yesterday, Chris talked about customers calling and being fearful that the ‘hot currencies’ were near their highs. Well… With the negativity toward the dollar running at all time highs, there’s just one reason to believe that the dollar could turn around… And that reason is if the Fed is forced to come back with one or two rate hikes to fight inflation.

“But, ask yourself this question, ‘Do I believe the Fed can afford to pick a fight with inflation with the mortgage meltdown going on?’ If you say yes, then you expect the dollar to recover at least short term. If you say, ‘Heck no!’ then look for further currency strength.

“Me? I’m in the ‘heck no’ camp! But one can’t simply forget about that risk of a Fed rate hike. But then again, if you listen to Big Ben, as Chris said yesterday, he’s beginning to sound dovish.

“How about that Chinese renminbi (CNY)? That 11.9% economic growth figure will go a long way toward pushing the renminbi closer to the 7.50 level that I said over a year ago would happen.

“And British pound sterling (GBP) is still champing at the bit to get to 2.10. You have to think that this will be accomplished as interest rates are still headed to 6%. It won’t happen overnight, so be patient grasshoppers!”

So as Chuck sees it, the risk to this dollar free fall is a sudden move by the FOMC to raise rates. I think everyone knows I’m in the same camp as Chuck on that one; the U.S. economy just isn’t strong enough to withstand a rate increase by the FOMC before year-end. We will have to wait and see how the housing downturn plays out next year as to where the Fed takes rates in 2008. But for now they will hold them right where they are.

One country that doesn’t have to worry if their economy is strong enough to withstand a rate increase is China. In an announcement overnight, China raised interest rates by 0.27% (they sure march to the beat of their own drum! The rest of the world uses nice quarter point increments but not China!). This was the fifth move up by China’s central bank in the last 15 months. Consumer prices rose the most in almost three years in June and factory and property spending have surged. We continue to expect further rate increases before year-end.

So with rates moving up, you would expect the currency to have moved up also right? Not in China. While the Chinese seem to be moving a little closer to the letting the currency free float, they still set the peg each night. The Central bank decided to move the currency down a little in order to offset any pressure from the higher rates. Another move by the Chinese government announced today was aimed at their burgeoning middle class. Taxes on interest income were reduced from 20% to 5%. This cut is designed to encourage citizens and companies to invest more of their incomes instead of spending them. China is trying to do all they can to cool their economy without causing any dramatic reactions.

While the government moved the renminbi lower overnight, most economists are now expecting the renminbi to increase another 2 to 5 percent by year-end. “Moderately faster appreciation nicely fits into their policy mix,” according to a report by Standard Chartered Plc. “The exchange rate may be at the bottom of their toolbox, but given the latest figures they need to use all the tools at their disposal.”

The pound sterling rose to another 26-year high against the dollar after a report showed that U.K. economic growth unexpectedly quickened in the second quarter, stocking expectations of higher interest rates. Gross domestic product increased 0.8 percent, compared with 0.7% in the first quarter. This report will bolster the case for the BOE to keep raising the interest rate in the coming months. Look for another rate rise in September, and the currency to reach toward $2.10.

Another currency that has had a nice increase lately is the Indian rupee (INR). The currency has rose to a nine-year high as the economy has expanded at the fastest pace in almost two decades. The rupee is Asia’s second best performing currency this year, after the Thai baht, which restricted trading in their currency at the end of last year. The currency has gained 9.8% versus the U.S. dollar this year, and offers the highest interest rate in Asia at 5.35% APY for a three month CD.

And the currency looks like it still has additional room for appreciation as global investors continue to flood the country with investment flows. The rupee is an excellent opportunity for investors to take advantage of the Asian economic boom while earning an excellent interest rate. Because the currency is a little more difficult to trade, we have to have a minimum of $20,000 for an Indian rupee CD. Call the trade desk to place your order or for additional details.

Currencies today: A$ .8798, kiwi .7954, C$ .9584, euro 1.3788, sterling 2.0528, Swiss .8293, ISK 59.48, rand 6.8868, krone 5.7315, SEK 6.6493, forint 178.10, zloty 2.7249, koruna 20.4840, yen 122.25, sing 1.5107, HKD 7.8205, INR 40.3125, China 7.5732, pesos 10.7628, dollar index 80.49, Silver $13.30, and Gold… $676.65

That’s it for today… We had a great evening last night as the entire trade desk surprised Chuck with a pizza party. I have to say thanks to his beautiful wife Kathy for not throwing us all out when we arrived at her front door! He is in great spirits and continues to recover. He is able to put about 50% of his weight on his rebuilt hip and is gaining more and more mobility. Chuck told us the big boss, Frank Trotter, had been over earlier yesterday to film a short piece for the presentations we are going to give next week in Vancouver and San Francisco. The video clip will be a poor substitute for the real thing, but at least it will give attendees a quick fix of Chuck (the guy they all come to see!). It is supposed to be a fantastic weekend here in St. Louis, I sure hope everyone has a good one!

Chuck Butler — July 20, 2007

The Daily Reckoning