The Resilient U.S. Consumer

Good day… I wanted to start off with a thank you for all the notes regarding Chuck’s health. He emailed me last night and let me know he read your emails and they are giving him additional strength going into today’s surgery. Several readers have asked where they can send cards, I think emails are the easiest way to show Chuck your support. You can simply reply to this email and I will make sure your message gets to Chuck. I have to say I have been touched by the outpouring of support, I can see the Pfennig community is a huge extended family. I will continue to try and keep everyone updated on Chuck’s status. Now on to the currency markets.

The dollar continued to trade in a fairly tight range yesterday even after the retail sales number came in at double the economists’ estimates. Retail sales in the United States jumped by the most in more than a year in May increasing 1.4%. The labor department also reported that import prices climbed 0.9%, also more than analysts predicted. These numbers seem to suggest that the U.S. economy is beginning to grow again, eliminating the need to cut rates. In fact, some traders are again betting the Fed will have to raise interest rates by year-end due to the pickup in inflation.

Today’s producer price data will add more fuel to these calls for an increase in rates, as PPI is expected to show a 0.6% gain in May. As with the retail sales number, the producer price number is being driven by the jump in fuel costs, which trickle down to drive up the prices of just about every item we buy. I don’t think anyone can argue that global inflation is heating up, and that interest rates need to be raised in order to combat this inflation. But in spite of yesterday’s numbers, which suggest that the U.S. economy is growing again, I am still not convinced the U.S. economy has “turned the corner.” The FOMC will not be able to raise rates to combat this inflation; they are going to have to keep rates right where they are whether or not inflation continues to increase.

Yesterday afternoon brought us the release of the Fed’s Beige Book, which gave an upbeat assessment of U.S. regional economies, as manufacturing and job growth picked up. This lends credence to the forecast by Chairman Ben S. Bernanke and his colleagues that U.S. economic growth will rebound from last quarter’s pace of 0.6%, the slowest in more than four years. So the book, which is published by the Fed, is currently painting the perfect picture of the U.S. economy: Slow growth without immediate inflationary pressures. Over the next few weeks we will see if this book goes in the Fiction or Non-Fiction section! I think you know where I think it should be filed!

The Swiss Central Bank raised its benchmark interest rate to a six-year high today and said more increases are likely to prevent an expanding economy and weaker franc from stoking inflation. SNB President Jean-Pierre Roth toughened his tone on inflation today as the decline in the franc pushes up the cost of imported goods. “Switzerland’s economy is in excellent shape,” Roth said at a press conference in Bern today. “Should economic momentum remain unchanged or should movements in the Swiss franc result in further relaxation of monetary conditions, further increases in the interest rate are likely in the months ahead.” I still feel the Swiss franc is one of the best investments going into the end of this year. The carry trade, which has kept the franc down in value, will start to unwind, and the Swiss economy will continue to benefit from the growth in Europe.

And I am not the only one who is predicting a reversal of the “carry trade”. Goldman Sachs Group said overnight that greater fluctuations in the prices of stocks, bonds, and currencies probably will erode profits from the carry trade. A Goldman index that tracks three-month implied volatility on options on eight major currency pairs is increasing. Implied volatility, which traders quote as part of setting option prices, indicates expectations for future price swings. This increased volatility will make the carry trade less profitable and may signal the beginning of a reversal.

But for now, the carry trade looks alive and well as indicated by the yen (JPY) dropping to 123 and the emerging market currencies moving back up. The yen has dropped due to expectations that the Bank of Japan will probably keep interest rates unchanged tomorrow. Most economists predict the bank will raise rates in August after the quarterly Tankan business confidence survey. The carry trade will start its reversal as soon as the BOJ moves rates, and the eventual move will only get more dramatic the longer it goes.

Chuck sent me a note late last night (he just can’t keep himself from watching the currency markets and sharing what he learns with his Pfennig readers). He forwarded me this from his trader friend at RBC:

“The U.S. Treasury refrained from naming China as a currency manipulator in its semi-annual Report to Congress on International Economic and Exchange Rate Policies, which has avoided a potentially negative outcome for the USD. But RBC expects that the CNY will continue to lead gains in the Asian region against the USD, which will only perpetuate the expected USD decline through H2 2007. We have a target for USD/CNY of 7.35 by end- 2007.”

The U.S. Treasury concluded no country or region among the 23 countries or regions included in the report met the technical requirements of currency manipulation for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade, but a significant increase in the growth in China’s current account surplus and in China’s dependence on the external sector for growth raised China to the top, or near the top, of all three schemes.

While the U.S. treasury failed to label China as a currency manipulator, four U.S. Senators introduced legislation that would allow American companies to petition for steeper import tariffs to counter the benefit of any undervalued currencies in China or other countries. The proposed legislation could start a trade war, which would be negative for both the U.S. and Chinese economies. No one benefits from a trade war, and hopefully this legislation won’t be able to make it through.

Currencies today: A$ .8370, kiwi .7512, C$ .9369, euro 1.3306, sterling 1.9687, Swiss .8037, ISK 63.28, rand 7.2180, krone 6.0932, SEK 7.0771, forint 190.08, zloty 2.8734, koruna 21.51, yen 122.96, sing 1.5426, HKD 7.8169, INR 40.94, China 7.6306, pesos 10.9202, dollar index 83.09, Silver $13.03, and Gold… $648.85

That’s it for today… Chuck was scheduled to be in surgery by now, please keep your thoughts and prayers with him. I sure hope this turns out to be a great Thursday!

Chuck Butler — June 14, 2007

The Daily Reckoning