RBA Rate Announcement Surprises the Markets

The currency markets warmed up a bit yesterday, as investors gained confidence and moved funds back out of the ‘safe haven’ of the US dollar. The main driver of investor confidence was the ISM Manufacturing Index, which expanded in January at the fastest pace since August 2004. The index rose to 58.4 in January from December’s 54.9 level. Any reading above 50 signals expansion in the US manufacturing sector. The surprising strength of this index had investors shifting funds back into the higher yielding assets yesterday, and selling dollars. Chuck took a look at the ISM numbers yesterday, and sent me the following on his way out the door:

“The ISM Manufacturing Index for January came in much stronger than expected, at 58.4 (55.5 was the forecast). Now… It certainly looks like the rot on the Manufacturing Vine is healing… But what happens if the dollar rally continues, and… Exports get deep-sixed?

“Yes… A strong dollar doesn’t necessarily help manufacturing… But then, if your country really makes things that the rest of the world wants, then it makes no difference how strong your currency is… But… If you’re out there pleading and begging with people to take your exports, then the value of the currency is very important… I think we all need to remember that… (Of course, it would be more helpful if traders remembered that!)”

I always appreciate Chuck leaving me his thoughts on the way out the door, and I think he is bang on regarding the recovery in the manufacturing sector.

The rest of yesterday’s data here in the US seemed to confirm an improving US economy; with consumer spending increasing for a third straight month. As Chuck pointed out yesterday, we can’t have much of a recovery here in the US without a strong consumer; and with unemployment expected to hold at double digits for the entire 2010, a strong recovery is questionable. But investors weren’t worried about the long term yesterday, and instead trumpeted the higher consumer spending numbers as a sign the US economy would continue to strengthen.

With stronger data releases in the US, the dollar lost ground. Yes, we are back to the old trading pattern where good news for the US economy means bad news for the dollar. When investors feel a bit more confident about the recovery here in the states, they start to look for higher returns. This means they can sell their ‘safe haven’ holdings of low yielding dollars and move the funds back into higher yielding currencies and investments.

While the dollar lost ground generally, the one currency that was having trouble appreciating yesterday was the Aussie dollar (AUD). Late yesterday afternoon traders began to price in the possibility that the RBA would pause, and not raise rates. Overnight, they did just that, with RBA Governor Glen Stevens surprising the markets by keeping rates steady. The move surprised economists, who had been unanimous in their prediction of a 0.25% increase. The Australian dollar slid dramatically as investors moved funds into other higher-yielding currencies. The Aussie dollar moved through the 88-cent handle immediately following the rate announcement, but then managed to climb back up above in European trading. But the worst may not be over yet, as many currency traders are now predicting a drop to 85 cents if the markets begin to bet on an early increase in US rates by the Federal Reserve. But neither Chuck nor I believe the Fed will have the cojones to raise rates with double-digit unemployment here in the US. And the pause by the RBA is just that, a pause! It is not a change in the direction of future interest rate moves. The RBA will come back to the rate table with another increase, and last night’s action will be quickly forgotten. While the Aussie dollar may drift lower, any move back into the 87-cent handle should be seen as an excellent buying opportunity.

Two of the currencies that benefited the most from the sell-off by the Aussie dollar were the South African rand (ZAR) and the Norwegian krone (NOK), both of which increased versus the US dollar. The Norges bank will be meeting tomorrow and had been expected to keep interest rates steady in Norway. But last night’s surprise move got the traders primed for more surprises, and some are now pricing in the possibility that the Norges bank will look to raise rates. I am still with Chuck on this one, and don’t expect any surprises out of either the Norges bank or the ECB which will conclude their meeting Thursday.

The South African rand climbed to the highest level in almost two weeks as investors were attracted by the yield differentials, which are some of the widest in the developed world. The rand also benefited from a strong move by gold yesterday. Gold is South Africa’s biggest export earner so the $25 move in prices helped boost demand for the rand. Investors looking to diversify out of the US dollar are shying away from the problems with the euro (EUR) and are looking increasingly toward the commodity-based currencies of South Africa, Norway, Canada (CAD), and even the Brazilian real (BRL).

Speaking of the real, it looks like it may finally be bottoming out. A news report that I read last night stated that options traders are dropping their bearish bets against the Brazilian real at the fastest pace since April. Another item helping the real overnight was a report released by Goldman Sachs Group Inc. who recommended that investors buy Brazil’s currency. “Brazil’s growth has remained strong and is accelerating,” a research note to clients stated. Goldman predicts the currency will rally from the current levels to 1.75 in the medium term (an increase of 5.5%). With one of the highest interest rates we currently offer, the Brazilian real may deserve another look for the speculative dollars in your currency portfolio.

While the currency traders were focused on the surprise announcement out of Australia, and continuing problems in Greece, most of the news stories here in the US revolved around President Obama’s proposed budget. As you have probably already read or heard, the 2011 budget calls for $100 billion in additional stimulus spending which will push the projected deficit to a record $1.6 trillion. His plan also calls for $800 billion in higher taxes on those earning more than $250,000 and additional fees on banks that got bailed out by the taxpayers.

As part of this budget proposal, the Obama administration also released their forecasts for unemployment and GDP. The administration has had to adjust their predictions for unemployment, admitting that their earlier predictions of a rate below 10% were too optimistic. They now predict the rate will average 10% during 2010, and will remain above 6% through the next five years. We all know the real unemployment numbers are substantially above this ‘official rate’ and I believe these high jobless numbers will keep the US economy from recovering in the near term.

But the administration still believes we are going to have a strong ‘jobless’ recovery! While they adjusted their forecasts for unemployment, they actually increased their prediction for GDP in 2010 to 2.7% from their previous prediction of 2%. They also kept their call for a 3.8% increase in GDP for 2011. Just what are the boys in Washington smoking? Do they honestly believe we are going to see a very strong GDP recovery with unemployment staying in double digits? Chuck and I sure aren’t buying into their rhetoric. Here is another note he left me yesterday:

“Don’t think the hard assets crowds weren’t freaked out by the president’s budget proposal yesterday? Gold shot up $25, before I went home for the day! That’s the best 1-day performance for gold in a month! And the budget proposal got others thinking too, that maybe, just maybe the dollar rally has stalled…

“I don’t know about you… But as far as I’m concerned, these budget deficits are giving me a rash! Remember when I used to bang on the previous administration when they would book $350 billion budget deficits? I thought that was unsustainable… And it proved to be! Now they are $1 trillion and more each year! I did see that $100 billion of that budget is another ‘stimulus’… The ‘Jobs Bill’ that I talked to you about yesterday… Great… Just great! We’ve become Japan, circa 15 years ago…”

The deficits in the US are definitely unsustainable, and will eventually force action by the administration. Unfortunately, the markets aren’t as easy to fool as the news media, and our administration will not be able to continue to push out the ‘judgment day’. We will likely see our interest rates forced higher, as the printing presses continue on overdrive in an attempt to ‘inflate away’ our growing debt. The ultimate consequence of these massive deficits will be a much weaker currency, and higher interest rates.

The Daily Reckoning