Steady Hands Prevail

Good day… The currency markets rallied again as investors moved back into positions abandoned over the past few days during the equity meltdown. I had several investors question why everything got sold last week. “Isn’t the currency market supposed to be a good hedge against a drop in the equity markets?” Not exactly. All of the markets are somewhat inter-connected, and when we get a sudden sell off like we did last week, investors run for the cover of U.S. treasuries or cash.

While the reversal of the carry trade had a lot to do with the fall of the high yielding currencies, this explanation really doesn’t fit with the fall of the euro (EUR) or Norwegian krone (NOK). These currencies were sold in order to book profits. Here’s how it worked: A hedge fund or money manager had money invested into various equity and debt markets. These markets fell dramatically due to data that showed the housing markets were going to continue to be a drag on the economy for an extended period of time. The hedge fund or money manger sells into the drop and books big losses on these trades. With month’s-end quickly approaching, these investors have to look for someplace to book some profits to offset these losses. So the currency positions get sold to book profits to offset the big losses in the debt and equity markets.

So the key for investors in these panicked markets is to keep a steady hand and don’t try to outsmart them. I heard a speaker at the conference last week put it in very good terms: “You never make a good decision in a panic.” Step back, take a deep breath, and remember why you made the decision to purchase the assets you have. I’m not saying to just ignore market movements, and if the opportunity to sell something you have wanted to dump comes up, go ahead and take it. But don’t make irrational decisions based on one or two days of volatile markets. Our products are designed for portfolio diversification and not for spot forex day trading. We suggest looking at currencies with good fundamentals and which look like they are trending up. I know it can be boring, but asset diversification will consistently beat “market chasing” over the long term. Steady hands will always prevail.

The markets have calmed somewhat, but there is a veritable plethora of data due out today, any of which could get them moving again. We will begin with the release of personal income and spending along with the PCE number, which is one of the Fed’s most closely watched inflation gauges. These numbers will be followed by the employment cost index, Chicago purchasing manager index, construction spending, and two different gauges of consumer confidence.

The number to watch is the PCE core number, which is expected to come in at 1.9%, year-on-year, slightly higher than the Fed’s comfort level. Any number above this would send the stock markets back down on fears of a FOMC rate increase. But, on the other hand, any positive news would help move traders back into assets, which were dumped last week.

The gains overnight in the euro will likely be limited by the release this morning of European business and consumer confidence, which fell more than economists forecast in July. Confidence in both Germany and France fell in July. Near record oil prices are to blame for this drop in confidence to 111 from 111.7 in June. But to put it in perspective, any number above 100 is positive, so the drop really isn’t a major story. Offsetting this bad confidence number was the release of German unemployment, which fell more than forecast in July and is now at the lowest level in 14 years. Retail sales in Germany were also released and showed a rise of 0.7% from May to June. This rise in retail sales and drop in unemployment in Europe’s largest economy will likely increase pressure on the ECB to raise rates.

Speaking of the ECB, a story on Bloomberg this morning did a great job of explaining that while the European Central Bank might be run by a Frenchman, its heart and soul belongs to Germany’s Bundesbank. ECB President Trichet faces political pressure to stop raising interest rates, but he will likely uphold the legacy of Germany’s central bank, which celebrates its 50th anniversary tomorrow. The Bundesbank’s inflation fighting zeal remains at the heart of European monetary policy even after the bank ceded control of rates to the ECB in 1999.

Both the Australian (AUD) and New Zealand dollars (NZD) rebounded from an eight-week low versus the yen (JPY), as a recovery in U.S. stocks gave investors confidence to move back into the carry trade investments. Chuck emailed me last night questioning these moves back into the high yielders. We have seen these sharp reversals before, and so far, the carry has returned and the currencies have recovered. But one of these times the carry will be reversed for good, and the high yielders will be sold for good. Again, we believe you have to look at investments in the Icelandic krona (ISK), South African rand (ZAR), or even the New Zealand Dollar as speculations. Keep these investments to a smaller overall portion of your assets.

With the move back into carry, the Japanese yen got hit back to trade just over 119. Again, this currency movement is solely due to the re-establishment of the carry trade. Investors will be able to profit from future reversals by buying back into the yen at the current levels. It takes a patient investor to hold the yen, but as you can see from last week’s movements, when the carry trade reverses, the yen can strengthen pretty dramatically.

Chuck also had China on his mind last night, and had this to say regarding the Chinese renminbi (CNY) and all the jawboning Hank Paulson has been doing:

“How about the performance of the Chinese renminbi? Pretty impressive, don’t you think? The acceleration has been the stuff that strong currency rallies are made of. Don’t think for a minute that this is a result of U.S. politicians and their pressure to float the currency. I’m sure these knuckleheads are high-fiving each other, thinking they’ve beaten the Chinese into submission… But, that couldn’t be farther from the truth!

“I spoke yesterday about the latest trade bill to punish China that was passed by the Senate Finance Committee on Friday. I just can’t get over the fact that these types of trade bills are coming at a time when credit is being crunched. I believe the dark clouds are forming for the United States on this, and I don’t think the storm is going to pass!

“OK… Now for my soap box… Did you see/hear U.S. Treasury Secretary Paulson talking about the subprime mess? The collapse in subprime mortgages doesn’t pose “any threat to the overall economy,” U.S. Treasury Secretary Henry Paulson said last week. I think Chris talked about this, but here are my two cents worth…

“Did you really think that Paulson would tell us to batten down the hatches? Stop in our tracks because the road ahead is dangerous? Or… Why would he? He’s a puppet. Which reminds me of an old 60’s song… I’m your puppet… Just remember that, when Paulson opens his trap! He’s not there to protect us… Shoot Rudy, he’s not even there to protect the U.S. dollar!”

Currencies today: A$ .8604, kiwi .7727, C$ .9440, euro 1.3708, sterling 2.0329, Swiss .8298, ISK 61.05, rand 7.0842, krone 5.8082, SEK 6.7066, forint 182.67, zloty 2.7640, koruna 20.4603, yen 119.44, sing 1.5103, HKD 7.8255, INR 40.37, China 7.5745, pesos 10.89, dollar index 80.85, Silver $12.965, and Gold… $667.78

That’s it for today… I forgot to let everyone know that this is the week Chuck is supposed to be a grandpa! His daughter Dawn is due to give birth to a little girl this Friday. I’m planning on visiting Chuck later this week, and his daughter is almost always there checking up on him, so I will let you know how she is doing. Speaking of babies, I spoke to Jennifer yesterday and could hear her new baby Drew in the background. Both Jen and Drew are doing great, and we can’t wait to get her back in here! Just a little short handed today, as we get two people back and send one away on vacation. Hope everyone has a great end to July and a happy Tuesday!

Chuck Butler — July 31, 2008

The Daily Reckoning