Markets Believe US Rates Will Move Higher

We had another uneventful day in the currency market, with the dollar losing some ground in the morning, but then rallying back up as the day wore on. Overnight, the dollar lost ground again and is trading almost back to where it began yesterday morning. There just isn’t anything to drive the markets, as investors are content to book the gains they have already earned for 2009. There will be a couple of big data days this week, but barring any major surprises, the traders seem content to just stay on the sidelines until 2010.

We have two TVs on the new trading floor so we can monitor a couple different news channels. It seemed like every time I glanced up yesterday there was another talking head spouting on about how the FOMC would be raising rates sooner rather than later. No matter the channel, the latest ‘sure bet’ is that the FOMC will be forced to raise rates early in 2010 as the US economy recovers. The US Treasury yield curve reflects this popular theory.

The yield curve, which is a good barometer of the health of the US economy, steepened with the 10 yields 282 basis points higher than the yields on 2-year maturities. Investors have forced yields higher on the longer term debt as the bet the recovery in the US will fuel inflation and hurt demand for treasuries at the Treasury auctions scheduled for the last week of the year.

But I’m still not convinced the recovery in the US is for real, and I share this opinion with someone who has pretty high-powered credentials. Nobel Prize-winning economist Joseph Stiglitz warned there is a ‘significant’ chance the US economy will contract in the second half of next year according to a story I read in Investment News. “The likelihood of this slowdown is very, very high,” Stiglitz told reporters in Singapore. “There is a significant chance that the number will be in the negative range.”

Federal Reserve Bank of Chicago President Charles Evans told CNBC that the US jobless rate would probably stay ‘quite high’ throughout 2010. He also said inflation, ex food and energy, would be little changed during next year. Fed policy makers kept their pledge to keep interest rates ‘exceptionally low’ for an ‘extended period’. Without an improving labor market, the Fed will not want to raise rates and risk the fragile recovery. So all of the folks talking about an early exit from the loose monetary policy could be extremely disappointed. But for now, the US dollar is enjoying a rebound as investors seem convinced that rates in the US will rise.

The one currency that did book a gain versus the US yesterday was the Canadian dollar (CAD). The loonie was one of the best overall performers and strengthened to the highest level in a year versus the euro (EUR). The move was sparked by strong retail sales numbers for October which were released in the morning. The loonie’s move higher picked up steam after it traded above its 52-week high versus the euro. It seems the ‘fair value’ of the Canadian dollar is right around parity with its southern neighbor; and if rates in Canada start moving back up, the loonie will continue to climb back toward $1.00.

Oil prices have been climbing over the past week, and have helped carry both the Russian ruble (RUB) and Norwegian krone (NOK) higher versus the US dollar. The Norwegian krone had a very good trading session in Asia, but then backed off a bit in European trading. But the earlier gains kept it as the best performing currency versus the US dollar in the past 24 hours.

The Australian dollar (AUD) and British pound (GBP) were two of the worst performers versus the US dollar. The Aussie fell to its lowest level in nearly three months as the talk of higher US rates drove investors out of their ‘carry trades’. As the global economies emerge from their recessions, yield differentials will be a major driver of currency values. Australia, which already started to raise rates, and Norway, which was the first European central bank to raise rates, both should benefit from widening rate differentials with the US. But as I wrote earlier, some investors now believe the US will raise rates sooner than previously believed. Higher rates in the US would hurt the high yielding currencies of Australia and New Zeeland (NZD), but I still am not convinced rates will be moving higher in the US anytime soon.

Speaking of New Zealand, Chuck has written about New Zealand’s current account deficit problems several times over the past few years. The persistent deficit is one reason Chuck has been a bit reluctant to suggest investments into the kiwi. So the news out of New Zeeland overnight is welcome. New Zealand posted the narrowest annual current account deficit in six years with the shortfall shrinking to just NZ$5.72 billion. Economists had predicted a deficit of over NZ$6.5 billion. A report released later today will probably show that the economy grew for a second straight quarter in the three months ending in September. If the current account deficits can continue to shrink as growth picks up, the kiwi could again become one of our pick currencies.

To recap, the US dollar continues to trade in a tight range, the yield curve in the US predicts higher inflation, oil prices support CAD and NOK, AUD and NZD trade off on yield differentials.

The Daily Reckoning