The Dollar Reverses

Good day. The dollar advanced over the weekend, wiping out all of Friday’s losses with the Euro not able to hold on to the 1.27 figure it reached late that day. But even after wiping out Friday’s gains, the currencies are just slightly below where they were trading at the close on Thursday.

The dollar’s advance this weekend was due to an increase in the fighting in Lebanon and speculation last week’s drop already reflects the likelihood that the Fed is nearing the end of rate hikes. The dollar slid from three-month highs last week as Fed Governor Ben Bernanke signaled a pause in the central bank’s rate cycle might be appropriate as economic growth slows.

This week we will get plenty of data from the United States, which should give us a better picture of just how strong the U.S. economy is. July’s consumer confidence will be released tomorrow along with existing home sales for June. These reports are expected to show confidence slid in July accompanied by a decrease in existing home sales.  Wednesday will be a pause on the data front as the only release is the Fed’s Beige Book.  The end of the week should be much more volatile as we will get durable goods, weekly jobs data, and new home sales on Thursday, followed by GDP and personal consumption on Friday.

I believe these figures will signal the Fed’s interest-rate increases are slowing growth in the United States and will keep the prospect of a rate pause on the agenda. Friday’s GDP report will be especially important as it is expected to show a dramatic turnaround from the blistering 5.1% growth in the first quarter. This data should lead the dollar back to the downward spiral we have seen so far this year.

But the bulk of this data won’t be released until the end of the week, so look for today’s trading to be dictated by events in Lebanon and Israel. As I mentioned above, the U.S. currency benefited from few signs of an easing of tensions in Lebanon, where Israel stepped up raids on Hezbollah targets. Apparently, Israel is meeting with stiffer resistance than it had expected in their attempt to secure the area just north of their border. With tension in the Middle East escalating, and barring any dramatic breakthrough by Secretary of State Rice, look for continued safe-haven buying of the dollar.

Investors should take advantage of these buying opportunities as they appear. Again, I look for the “end of week” data to confirm what Fed Chairman Bernanke has warned – that the U.S. economy is slowing and our ability to withstand further rate hikes is slipping. While we will probably still see one more rate hike in August, it is definitely looking like the Fed will pause after that.

The Japanese yen came under additional selling pressure as a government report showed prices excluding fresh food fell in June for the first time in a year. The Bank of Japan is extremely worried about slipping back into a deflationary environment, so the markets believe this data will keep them from making any additional rate hikes for the remainder of 2006. As Chuck pointed out to me in an e-mail this last night (I guess he couldn’t sleep after the long journey to Vancouver), it is not really a question of Japan having interest rates equal to the United States. It’s all about making the yen more expensive to hold as a short position on carry trades.

So, if the Bank of Japan merely moves rates a few more times in the next year, it will have done just that. We still expect the Yen to rally as this “carry trade” reverses. And the rest of the Asian currencies will accompany the yen upward. By the way, our new Orient Opportunity Index CD, which is made up of yen, Singapore dollar, Thai baht, and the Hong Kong dollar, has been received very well. It is a perfect alternative to those that want Asian exposure, but don’t want the volatility that the New Zealand dollar has brought to the Asian Advantage Index CD. Call the desk for more details!

Speaking of the kiwi, we expect New Zealand’s central bank governor, Alan Bollard, will leave the benchmark interest rate at a record high this week and may signal no change this year as inflation accelerates. The rate decision will be announced Thursday and no change should help the currency hold it’s recent gains above 0.62.

New Zealand’s kissin’ cousin, the Aussie dollar, will also get support from a report that producer prices rose 1.6% in the second quarter, as more expensive fuel boosted manufacturing costs. The Reserve Bank of Australia raised interest rates in May to stem inflation, which is already at the top of its target band. We expect another rate increase in August as record oil prices, a three-decade low jobless rate, and rising wages are expected to drive faster inflation. As the Canadian dollar starts to lose favor with currency traders, the Australian dollar may be a good alternative to investors looking for a solid commodity based currency with good interest rates.

I will end today’s Pfennig with a quick word on China. Economic growth, which reached the fastest pace in a decade in the second quarter, may slow as the government takes steps to clamp down on lending. The government, on July 21, 2006, restricted funds available for lending for the second time in two months to cool an investment boom. We also expect the People’s Bank of China to raise interest rates for a second time this year to further curb spending. As Chuck has pointed out in the past, these measures will not work on their own, and we look for the Bank to continue to let the Chinese renminbi appreciate.

Currencies today: A$ .7523, kiwi .6218, C$ .8767, euro 1.2625, sterling 1.8530, Swiss .8020, ISK 73.03, rand 7.06, krone 6.30, SEK 7.33, forint 220.30, zloty 3.13, koruna 22.53, yen 116.64, baht 37.99, sing 1.585, INR 46.93, China 7.9875, pesos 10.95, dollar index 86.35, silver $10.84, and gold $615

That’s it for today. Beautiful weekend here in St. Louis as we continue to clean up from last week’s storms. It sounds like most of us on the trading desk have power at home again, but approx. 150,000 still are without in St. Louis. I just hope the temps stay below 100 this week! Take advantage of the buying opportunities over the next few days; I expect to see the dollar fall at the end of the week. Have a great Monday!!

Chris Gaffney
July 24, 2006

The Daily Reckoning