Range Bound in the U.S.

Good day… As predicted, the currency markets traded in a tight range over the past 24 hours. With no data released yesterday, and very little to move the markets today, I expect to see these flat trading patterns continue. Currency traders will be positioning themselves for the reports due later this week.

As always, the market has tried to predict what this data will show. Right now, the dollar has moved higher because traders think the reports will indicate a strengthening U.S. economy as U.S. retail sales rise, and consumer price gains accelerated in May. This would bring back calls for the FOMC to raise rates and quiet the calls for rate cuts.

But what happens if the data shows that the U.S. economy is continuing to slow? The dollar moves back into the downward trend it has been tracking all year. Most of the recent strength in the dollar has been caused by rate cuts being priced out of the market. If the reports due out later this week don’t confirm that the United States has “turned the corner”, the dollar will get whacked like an extra on the Sopranos.

The pound sterling (GBP) rose versus the dollar yesterday after BOE governor Mervyn King signaled that he might raise rates again this year. King said late yesterday that the BOE “may need to take further action” to contain inflation. King’s comments followed a report which showed consumer price inflation had slowed to an annual 2.5% in May, the lowest in seven months.

This report seemed to justify the BOE’s pause last week, so King’s hawkish comments surprised the markets. According to King, if “indicators of capacity pressures, pricing intentions and inflation expectations remain elevated,” then policy makers “may need to take further action.” Sounds like the BOE is ready to get a little more aggressive on rate increases. The pound will continue to be supported by interest rate differentials and I believe we will still see it trade near $2.07 by year-end.

Not to be outdone by Mervyn King, the ECB’s president Jean-Claude Trichet made it clear the BOE is not the only hawkish central bank. In a speech to European Parliament’s Economic and Monetary Affairs Committee yesterday, Trichet said, “borrowing costs are low enough to support economic expansion”. The Europeans continue to be very vigilant in their goal of price stability. And while some members are not happy with the tight monetary policies (Spain & Italy), the ECB has shown it will continue to do everything it can to keep inflation out of their economies. This is a major advantage of the single currency and the independent central bank.

New Zealand’s dollar (NZD) rebounded today after yesterday’s drop due to currency intervention. Chuck sent me the following comments on the kiwi’s recent drop and intervention by the RBNZ:

“Chris talked yesterday about how the Reserve Bank of New Zealand (RBNZ) and their Governor Mr. Bollard, had admitted intervening in the currency market to support the weak U.S. dollar, and weaken the kiwi. I was quite interested in this story because over the years I’ve seen only one Central Bank guide their currency and not very well.

“The Bank of Japan (BOJ) spent trillions to keep yen (JPY) from strengthening, only to see it go from 115 to 102. But in the end, the trillions spent did keep the yen from going any higher. (Remember, that yen is a European priced currency, so the lower the number, the greater the value versus the dollar.) But what Central Bank besides the BOJ could waste trillions of reserves like that? Hmmmm… Well… The Peoples Bank of China could, and that’s it!

“So… Getting back to the RBNZ, what did they have to gain by intervening by themselves? A short-term move in the currency… That’s it! The only way the RBNZ can play this game is with other Central Banks in a concerted effort to strengthen the dollar. Unfortunately, the RBNZ is the only player in this game, and if that remains the case, they are going to end up with egg all over their face. They will not win this game… And they will not guide their currency lower. In fact, currency speculators haven’t had a fight with a Central Bank in a long time, and with the liquidity in the world today, I would guess they would welcome a currency fight at this time with open arms!

“These rising yields around the world are something to behold. I’m not quite on board with what’s going on either! I think we had better be careful chasing shooting stars… By that I mean, just because a currency’s yields have shot up recently, doesn’t mean its fundamentals support that move. And if the fundamentals don’t support it… Well, it leaves the rising yields and currency vulnerable. The U.S. dollar is the Big Kahuna here… Be careful.”

As you can see, central bank intervention gets Chuck pretty worked up.

The South African rand (ZAR) rebounded overnight as the prospect of higher rates lured investors back. Central bank Governor Tito Mboweni and other policy members lifted South Africa’s benchmark rate a half point last week, forecasting inflation will hold above the bank’s target in the second quarter. Unlike the ECB or BOE, it looks like the South African central back is behind the inflation curve, so a more aggressive interest rate policy is going to be needed. This currency has traditionally been one of the most volatile we have offered, and with the carry trade alive and well, continued volatility should be expected.

The Chinese renminbi (CNY) had the biggest gain since the end of the dollar link in July 2005. The move up came after a report that showed China’s inflation accelerated at the fastest pace in more than two years in May as pork prices soared. Consumer prices rose 3.4% from a year earlier, which was just slightly higher than the 3.3% expected by analysts. Inflation continues to outpace returns on bank deposits, encouraging households to put money into the stock market. Inflation will continue to put pressure on China to raise interest rates and/or let the renminbi appreciate.

There is another factor I believe caused China to let the currency rise overnight. The U.S. Treasury Department is preparing to release their semi-annual evaluation of exchange rate manipulation tomorrow. Treasury Secretary Henry Paulson failed to win any pledge on the currency during trade talks in Washington last month.

U.S. lawmakers plan to unveil legislation tomorrow to push China to loosen controls on the renminbi, hours after the Treasury report. China will likely continue to let their currency advance to try and deflect some of the criticism that will be aimed at them over the next two days. As we have said in the past, a stronger renminbi is good for the world’s economies, as it continues to be one of the most undervalued currencies.

Currencies today: A$ .8421, kiwi .7514, C$ .9422, euro 1.3340, sterling 1.9734, Swiss .8059, ISK 63.37, rand 7.2055, krone 6.074, SEK 7.034, forint 189.63, zloty 2.8709, koruna 21.33, yen 121.83, sing 1.5386, HKD 7.8156, INR 40.75, China 7.6450, pesos 10.9225, dollar index 82.77, Silver $13.15, and Gold… $651.55

That’s it for today… Should be another fairly quiet day in the markets with no real market moving data due out. But take advantage of the pause, as I think the end of the week is going to get interesting! They shut off the main entrance to our parking lot today as they begin to build another office building adjacent to ours. All the construction around us right now makes it a challenge just to get to work! Maybe we should all figure out how to work from home for a while ?!? Hope everyone has a great Tuesday.

Chuck Butler — June 12, 2007

The Daily Reckoning