Sarkozy and Merkel Calm the Currency Markets

It was a pretty busy day in the currency markets yesterday, so there is thankfully plenty to write about, this morning. The dollar has continued its slow retreat from Monday’s spike when the dollar index traded at the highest level since February 22. The big move higher by the dollar was the result of renewed fears of a eurozone break up and a downgrade of some major European banks, but leaders of both France and Germany have been working hard to assure investors the euro is here to stay. Our own Treasury Secretary Tim Geithner is in Europe today to throw his two cents into the discussion. I guess he certainly knows a lot about unfettered accumulation of debt, but I’m not so sure he knows how to bring deficits back under control. Like I said, there is plenty to talk about in the markets this morning, so let’s get to it.

The euro (EUR) rebounded a bit yesterday, and moved even higher overnight on assurances by leaders of the ‘big two’ euro countries. French President Nicolas Sarkozy and German Chancellor Angela Merkel said they are ‘convinced’ Greece will stay in the currency union. “Everything must be done to keep the eurozone together”, Merkel said on German radio. This seemed to calm fears that a euro-break up was imminent. But while the words seem to have calmed the currency markets, neither leader has put forth a credible plan on how to deal with the renewed attacks on Greek debt. One thing is definite; Greece is going to need additional help.

Greek leaders reaffirmed their commitment to austerity measures following a conference call among the leaders of Germany, France, and Greece. The International Monetary Fund, European Central Bank and European Commission representatives will be visiting Greece this week to evaluate what progress leaders have made on their austerity efforts. These representatives will then give their recommendation for the release of further loans to Greece. I don’t expect any surprises, as all indications are that the additional funds will be released, but there is always a risk that they find Greece has ‘cooked the books’ and could refuse to throw good money after bad. Again, I don’t expect this to happen, but the risk remains. Some of the funds for the Greek bailout will be coming from the European Financial Stability Facility (EFSF) whose powers are being further expanded in order to deal with the ongoing crisis. European governments still need to ratify a July 21 agreement to bolster the euro region’s bailout fund and extend a second rescue to Greece. This will serve as another opportunity for those opposed to the Greek rescue to make their points. There just doesn’t seem to be any end in sight for this European debt crisis, and the Euro will certainly remain under selling pressure for the near future.

A bit of good news, which certainly helped to calm investors’ fears, was the successful auction of Spanish debt. While the problems of Greece continue to be a nuisance to Europe’s leaders, if default fears migrate over to Spain or Italy, the European Union would almost certainly be sunk. The positive news on the Spanish debt auction was partially offset by the news that the European Union had cut its growth forecasts for the second half of 2011. The 17-nation euro region is now expected to expand just 0.2% in the third quarter, and 0.1% in the fourth, which is down from the EU’s previous estimates of 0.4% growth in both quarters.

Switzerland’s pledge to keep the Swiss franc (CHF) from appreciating against the euro is certainly not helping things. The SNB has been buying euro debt and selling Swiss francs in order to maintain the franc at ‘acceptable’ levels. But the Swiss aren’t buying any of the peripheral debt, and are concentrating their purchases on German and French sovereign debt (can you blame them?). Their purchases have caused the yields on ‘core’ European debt to fall, while rates continue to rise on the ‘peripheral’ debt of Greece, Italy, Ireland, and Portugal. The EU has been working to narrow the yield differentials of this debt, and the Swiss purchases certainly aren’t helping. Also, many investors who were purchasing the higher yielding debt of Greece and Italy were offsetting the risk of these purchases with the ‘safe haven’ of the Swiss franc. But the ceiling that the SNB has placed on the Swiss franc has taken away the gains available to these investors, and made them less likely to make the riskier investments into Greek and Italian debt.

The Swiss central bank held rates at zero, after lowering them from 0.25% last month. SNB officials reiterated that they will defend the new currency ceiling with the ‘utmost determination’ and said they are ready to take ‘further measures’ if needed to stem the gains of the franc versus the euro. The Swiss central bank officials agree with the EU in predicting that European growth will slow to a near halt later this year, and are not worried about inflation. But with rates at zero, and the central bank utilizing ‘unlimited purchases’ of euros in order to keep the Swiss franc lower, inflation concerns will have to start increasing.

Chuck left me a few thoughts on the markets yesterday, and in particular the lousy retail sales numbers which printed:

Remember when I told you that I believed the retail sales figure that would print this week, would be disappointing… Not really “bad” because of the back to school sales in August? But disappointing… Well… There must not have been many back to school sales, because the retail sales figure for August printed flat! That’s right… Retail spending in August remained unchanged in the month and compared to expectations of a 0.2% gain going into the report. And July’s figure which previously printed at +0.5% was revised down to +0.3%… So, retail sales were 0.3%… Flat for August, which once again is proving to the me, and the markets, and probably you dear reader, that this economy is going nowhere fast…

And it proves once again, that once the stimulus for the economy was pulled… everything will grind to a halt… Because the US economy has become addicted to stimulus… Waiting for… An economic hoola hoop… But until that comes along, the Fed Heads will once again think they know what’s best, and implement some sort of stimulus… We just have to wait-n-see…

It is going to be a busy data day here in the US, this morning, as the screen is chock full of releases. We will get a view of Consumer Prices in the US as August CPI data is released. Price increases are expected to have slowed from the levels they posted in July as a drop in raw material costs are expected to help companies hold the line on prices. Weak consumer demand will also help keep price increases in check. In addition to the CPI data, we will get the weekly jobless claims (expected to show a slight drop) and Industrial Production (expected to be flat).

Later this morning we will get the important Capacity Utilization numbers for August which is expected to stay stable at 77.5%. Chuck has always told us to keep a close eye on this number, as it is an excellent indicator of the strength of the manufacturing sector of the US economy. At a 77.5% utilization rate, manufacturers still have the ability to crank up production without bringing additional facilities online. We would need to see this number climb back up into the high 80% range before being convinced the US economy is on a sustained growth path.

New Zealand’s central bank left interest rates unchanged overnight, and signaled they would remain on hold for the foreseeable future. The recent strength of the kiwi (NZD) is helping to hold down inflationary pressures, and is also slowing growth in this export-driven economy. RBNZ Governor Alan Bollard told reporters today that there is now greater risk that the global economic activity will slow ‘sharply’ and he wants to be sure that doesn’t happen before raising rates. The kiwi moved lower versus the US dollar after Bollard’s statement was seen as more dovish than expected by currency traders.

A drop in the price of oil on global growth concerns caused the Canadian dollar (CAD) to fall back to near parity with the US dollar. The bad retail sales numbers released in the US yesterday also helped push the Canadian dollar lower as Canada ships about 75% of its exports to the US. While Canadian economic data supports a stronger currency than that of the US, Canada’s fortunes are definitely tied to the US. Parity certainly seems to be the ‘sweet spot’ for the Canadian dollar versus the US dollar, and I wouldn’t expect it to drop too much below parity, no matter what happens to oil or the US economy.

Precious metals are selling off this morning, with gold falling over $30 and silver flirting with the $40 level. I haven’t been able to find any reason for the big moves, but will continue to try and find the reason and will let Chuck know if I find anything.

And then there was this… William Ackman, founder of the hedge fund Pershing Square Capital Management LP is predicting that Hong Kong will be allowing its currency to appreciate versus the US dollar. He believes Chinese authorities will allow the currency to appreciate, breaking the peg which has held the Hong Kong dollar (HKD) within a very tight trading range with the US dollar. Tim Smith mentioned that we have had a number of investors calling the desk and asking about the HK$, so apparently Mr. Ackman has some followers in the EverBank WorldMarket community. There is some logic to his call, as the financial system in Hong Kong is more advanced than that of mainland China, so Chinese officials may decide to ‘test the waters’ in Hong Kong before allowing a large move by the renminbi (CNY). But I still believe the Chinese will continue their ‘slow and steady’ approach to currency adjustment. Expect small gains by both the renminbi and Hong Kong dollars versus the US dollar over the next few years.

To recap… The leaders of the ‘big 2’ European countries have thrown a lifeline to the euro after confirming Greece will stay in the EU. The SNB is purchasing euro debt in order to defend their new currency ceiling, but the moves are helping the EU. Retail sales in the US were disappointing, and growth looks to remain flat. Commodities all had a sharp selloff, and have caused the Canadian dollar to approach parity with the greenback. Finally, one hedge fund manager is predicting the Hong Kong dollar will be the ‘first to float’.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning