Swine Flu has Currency Traders Running for Cover

Good day… The swine flu continued to dominate the news wires yesterday, causing investors to seek refuge in the U.S. dollar. This really is the last thing the global economy needs right now, and hopefully the health officials will be able to keep it somewhat contained.

The country’s currency that continues to be most impacted is the one at the epicenter of the outbreak: Mexico. Tourism is Mexico’s third largest source of foreign currency behind oil exports and remittances from Mexicans living abroad. Even though most cases have been reported in Mexico City, travelers are now canceling or delaying plans to visit the coastal resort cities.

But tourists aren’t the only ones impacting the Mexican economy. Consumer spending has nosedived over the past week, as consumers in Mexico are keeping away from large public areas. And with the death toll rising above 100, the Mexican government has decided to order mandatory closures of public places. I spoke to one of our customers yesterday who had been in Mexico City over the weekend. He said the city was eerily quiet, with minimal traffic and many people on the street wearing facemasks.

The Mexican peso (MXN) continued to fall throughout the day, ending the day over 5% lower versus the U.S. dollar. The central bank tried to slow the currency’s slide, coming into the markets to purchase $400 million worth of pesos. But investors continued to move out of the peso denominated investments, taking refuge in U.S. treasuries. From what I have witnessed in the currency markets, the peso probably has further to fall, with a possibility of another 20% decline over the next couple of weeks.

For now, the damage has largely been contained to the Mexican peso; but the global economy could still take a major hit if the swine flu becomes a pandemic. Investors hate the unknown, and right now many are pulling back investments in emerging markets and parking the funds back in the Japanese yen (JPY) and U.S. dollar. While I understand the move back to the U.S. dollar (U.S. treasuries are still seen as the safest haven in the global economy), I don’t think the purchases of Japanese yen are safe haven moves.

The Japanese economy continues to be bogged down in a decade-long deflationary spiral, with consumer prices falling and stagnant economic growth. Data released out of Japan doesn’t indicate any changes on the horizon. Japan’s retail sales fell for a seventh month in March as worsening job prospects and declining wages prompted households to cut spending. Japan’s economy will likely shrink 3.3% this fiscal year, the sharpest contraction in the postwar period.

With all of these negatives, I can’t believe investors are rushing to purchase the yen as a ‘safe haven’. No, the yen purchases are not safe haven flows, but are simply carry trade investors moving back out of their trades. The Japanese yen continues to be one of the cheapest funding currencies for the carry trades. Carry trade investors have again started to reverse their positions, exiting the high yielders and paying back the loans denominated in the Japanese yen.

With risk aversion prevailing in the currency markets, the high-yielding currencies of South Africa (ZAR), Brazil (BRL), and New Zealand (NZD) continued to be sold. These currencies had posted some pretty impressive gains versus the U.S. dollar during April as investors’ comfort levels increased and they sought out higher yields. But the flu scare has put fear back into the markets, causing investors to again deleverage their positions.

Interest rate differentials are what drive the carry trade, and expectations of interest rate cuts by South Africa and New Zealand have also caused investors to move away from these currencies. South Africa’s central bank is expected to cut its benchmark rate by a full percentage point later this week in order to help spur consumer spending. South Africa’s economy has been able to continue to grow through the global downturn, but reports may show the economy contracted in the last quarter, causing the economy to dip into the first recession in 17 years.

And New Zealand central bank Governor Alan Bollard will probably decide to cut rates by 50 basis points on Thursday. Bollard was one of the first to aggressively cut interest rates, and with New Zealand’s recession now one and half years old, he feels he needs to continue to cut. Bollard has cut borrowing costs by 5.35% since July of 2008, and a 50 basis point cut will bring the cash rate to a record low of 2.5%. “Were the economy to have more bad news, it’s not inconceivable it could go lower,” Bollard said on March 12. “But to go much below that, we think, would be unlikely.”

Strike three for these currencies has been the global decline in commodity prices. Copper, aluminum, lead and zinc all slid due to mounting concerns of a further drop in demand. Oil has also slid, causing a sell off in the exporting countries of Canada (CAD) and Norway (NOK). The possibility of a global pandemic has decreased growth expectations, and lowered expected demand for crude oil. The expected drop in tourism has also decreased the need for jet fuel and gasoline. But even with all of these negatives, the South African rand, Brazilian real, and Norwegian krone are the top performing currencies versus the U.S. dollar this year.

Back here in the United States, the debts continue to grow. Yesterday the U.S. Treasury boosted its borrowing estimate for the second quarter by $196 billion. The Treasury Department said Monday that it would need to borrow $361 billion in the current quarter – a record amount for that period. This will be the third straight quarter that the government’s borrowing needs have set records for those periods. The announcements went largely unreported by the media who were overwhelmed by the swine flu stories.

The administration is now projecting that the federal deficit for the entire budget year ending September 30 will total a record $1.75 trillion. This would be nearly four times the previous record of $454,8 billion, which was set last year. In order to allow for the government’s huge borrowing needs, Congress boosted the national debt limit to $12.1 trillion as part of President Barack Obama’s stimulus program passed in February.

It will be interesting to see if the United States can attract buyers for all of this debt. And even if buyers show up at the auctions, all of this additional supply will have to begin pushing rates up.

One of my favorite economists, Nouriel Roubini, warned that a persistent recession and mounting unemployment would leave the U.S. financial system insolvent. Roubini, speaking at the CFA Institute’s annual conference yesterday, predicted that losses at U.S. banks and broker dealers would swell to $1.8 trillion as the economic slump lasts at least through this year and the jobless rate climbs to 12% by 2010. The losses would exceed the $1.4 trillion in capital that banks currently have, meaning, “the system in the aggregate looks insolvent,” Roubini said. I guess Roubini doesn’t think much of the stress tests that regulators performed earlier this year. “The stress tests are not really serious,” he said, saying that even the most adverse outcomes predicted by officials were too rosy.

A couple of currencies that have continued to increase through all of the current crises are the Chinese renminbi (CNY) and the Hong Kong dollar (HKD). People’s Bank of China Governor Zhou Xiaochuan said yesterday that China’s current-account surplus “will no longer be a serious problem” as the country’s economic stimulus boosts domestic demand. We have written about how China will be the economy that leads the world out of this economic quagmire, and the first step is for internal demand in China to tick up. Chinese stimulus has been directed at building and improving infrastructure, with a majority of the spending being directed to roads, bridges, and low-cost housing. These projects help to create new construction jobs and will put more money back into the hands of Chinese citizens. As we have noted in past issues of the Pfennig, even a slight increase in the standard of living for China causes a major uptick in consumption and global growth.

While some thought the Chinese goal of better than 8% growth was overly optimistic, Goldman Sachs Group last week raised its 2009 growth forecast for China’s economy to 8% from their previous estimate of 6%, citing the stimulus. The Chinese car market is now the largest in the world, and it is expected to continue to grow another 10% in 2009, up from 6% last year.

Finally, gold and silver sold off again overnight, with gold dropping back below $900 falling all the way to $886. I continue to believe the pullbacks are nothing more than excellent opportunities for purchases, as global inflation is bound to heat up. The precious metals are a traditional hedge against the possibility of run away inflation. Now on to the currency wrap-up.

Currencies today 4/28/09: A$ .7025, kiwi .5585, C$ .8176, euro 1.3004, sterling 1.4594, Swiss .8645, rand 8.8533, krone 6.7544, SEK 8.258, forint 228.28, zloty 3.5102, koruna 20.595, yen 96.23, sing 1.501, HKD 7.75, INR 50.46, China 6.8268, pesos 14.11, BRL 2.2236, dollar index 85.696, Oil $48.69, Silver $12.39, and Gold… $886.97

That’s it for today… Beautiful spring morning here in St. Louis. I ran through Forest Park, which is just gorgeous this time of year (it is the second largest inner-city park in the country. Central Park is larger.) The recent rains have the trees starting to green up, and the pollen is noticeably lower. Hope everyone has a Terrific Tuesday!!

The Daily Reckoning