Risk Off as US Data Disappoints

Yesterday was another busy day on the desk; it seems like investors are finally figuring out that in spite of the uncertainty in the markets, there are still some good opportunities. But while the flow of trades increased yesterday, the currency markets took a breather from their torrid pace on Monday.

What movement did occur yesterday was mainly due to a plethora of data releases in the US, which mostly disappointed. Personal income and spending in the US were both reported unchanged for the month of June, and May’s numbers were revised slightly lower. And while US consumers were feeling the pinch, prices rose a bit more than expected with the PCE Deflator moving 1.4% higher versus an expected 1.3% increase. So it was no surprise when the ABC Consumer Confidence number came in at -50, again worse than what was expected.

As I reported yesterday, the Fed’s head cheerleader, Ben Bernanke, believes the US consumer will be increasing spending over the coming months, and this increase will help push the US economy out of this ‘pause in the recovery’ (his words not mine). Either Ben doesn’t get the inside scoop on what the data is showing, or he is trying to pull a Greenspan and ‘jawbone’ the markets into submission. I would think it is the latter, as the Fed Chairman understands that a large part of his job is to try and move sentiment with his words. After all, if he ‘told it like it is’ we would all probably hunker down and hold on tightly to our wallets. This is exactly what St. Louis Fed President Bullard warned about this weekend; that US consumers could tighten up spending even more, sending the US into a deflationary spiral similar to Japan. I know deflation is a tough place to go for an economy, and would rather not go there, but it certainly isn’t hurting the Japanese yen (JPY).

The yen was the best performing currency yesterday, rising about 0.5% versus the US dollar and is now close to 8.83% higher on the year (blowing away all other currencies). The yen benefited from ‘safe haven’ flows, as the disappointing data in the US worried investors that the US wasn’t participating in the global economic recovery. The Bank of Japan, which has had a history of intervening in the currency markets, has stayed on the sidelines during this year’s rally versus the US dollar. A research note that I read yesterday suggested the BOJ doesn’t want to try to ‘go it alone’ versus the currency markets, and has been unable to convince either the ECB or US Fed to help intervene. No surprise there, as the ECB is enjoying the weaker euro (EUR) which has helped spur exports to Asia; and the Fed has other more pressing worries than a strong yen versus the US dollar. So the recent rally in the yen continues unchecked by intervention, and if the data coming out of the US continues to disappoint, the yen will probably breach the 15-year high of 84.83 set in November of last year.

Adding to the dollar’s woes yesterday was data released on pending home sales, domestic vehicle sales, and factory orders. Two of these three numbers came in worse than expected, with domestic vehicle sales being the only bright spot. Factory orders were down 1.2% in June, and pending home sales were 2.6% lower on the month, and 20.1% lower YOY! The housing market continues to suffer after the end of the homebuyer credit. As I mentioned, the automobile sector provided the only positive surprise with domestic vehicle sales up slightly along with the total vehicle sales.

The euro paused its recent assault on the dollar yesterday, holding just above $1.32. While data here in the US continues to disappoint, the data out of the Eurozone has been better than expected. A report this morning showed that growth in Europe’s service and manufacturing industries accelerated in July to 56.7 from 56 in June. Exports are the driving force behind much of the improvement in these industries, with many of these exports heading to China.

China has now overtaken Japan to become the world’s second largest economy. And while cheap exports out of China have been one of the favorite excuses used by the US administration for the downfall of the US, China has had a fairly substantial shift toward consumption. Decades of rapid growth have lifted hundreds of millions of people out of poverty, and this new ‘middle class’ has become a good market for goods and services. According to projections by the World Bank, China is now on course to overtake the US as the world’s largest economy sometime around 2025.

Whenever I write about China’s surging middle class, readers point out that the standard of living is still substantially below that of the US or Europe; and they are correct. The per capita income in China is about $3,800 a year, hardly enough to buy any of the BMW’s coming out of Germany. But this per capita income is skewed by the huge number of Chinese still living in rural areas, who are still not participating in the capitalistic reform. Those that are living in the burgeoning cities are quickly finding out the joys of having disposable income, and will continue to help propel the global economic recovery.

And while consumption of finished goods are expected to increase with the expanding middle class, they will also continue to demand more raw materials. This will boost the prospects for the countries that supply these raw materials to China, including the Australian dollar (AUD), Brazilian real (BRL), and Canadian dollar (CAD). All three of these currencies were up slightly on the day and continue to be some of the most popular currencies we offer. Investors are especially drawn to the high interest rates of Brazil and Australia, where rates are expected to trend higher due to rising inflation.

The only thing keeping a lid on these currencies is the ‘risk off’ trading pattern, which has investors moving to the safe havens of the yen and dollar whenever the global recovery is questioned. But long term, investors will not be happy sitting in the low yields of Japan and the US; so the higher yielding currencies of Australia and Brazil would certainly seem to be attractive alternatives.

Gold gained overnight and is spitting distance from $1200 this morning. Poor US economic data has caused some investors to look at precious metals as an alternative investment. Gold is what Chuck has called an ‘uncertainty hedge’ and the data out of the US certainly increases the uncertainty for US investors. Gold has also traditionally been a good hedge against inflation, and while inflation rates continue to be held unusually low, the QE programs instituted by some of the major central banks will eventually lead to higher inflation rates.

To recap: US data continued to disappoint investors, sending them into the Japanese yen and gold; China passed Japan to climb to the #2 global economy (and #1 is not too far away); and commodity currencies are still some of the favorites of the desk.

Chris Gaffney
for The Daily Reckoning