The View from Fenton

Good day… I went by to see Chuck last night, he is looking great and getting stronger each day. As usual, his thoughts about the day’s events were waiting on me when I got in this morning, so here they are:

“Yesterday was ‘visitors day’ at my house, as I was visited by my colleague Jen and her five-week-old son, Drew, for lunch. Then at dinner, I was visited by my good friend and partner Chris Gaffney, and Lizzie Brown, a colleague of mine that once helped me with the Review & Focus each month. I love when people come to see me!

“One of our sharp guys (thanks Jim!) down in Jacksonville sent me a story yesterday that goes right into what I’ve been trying to tell people about the subprime meltdown, extending its tentacles to other parts of the economy. Here are snippets from the story…

“‘Railroads, chemical producers and insurance companies are blaming the worst U.S. housing slump in 16 years for their earnings woes.

“‘DuPont Co., the third-largest chemical maker, said slumping demand for kitchen and bathroom countertops was partly responsible for its profit drop. Genworth Financial Inc., the former insurance unit of General Electric Co., said earnings will be at the “lower end” of its forecast this year as mortgage-insurance claims increase.

“‘”The subprime slime is oozing,” said Gary Shilling, president of A. Gary Shilling & Co. in Springfield, New Jersey, who correctly predicted the recession in 2001. “As home equity evaporates, that takes out the foundation of strong consumer spending growth, which has been the mainstay of the economy.”‘

“OK… Onto other things that go bump in the night. The ISM Index, which measures the national manufacturing heartbeat, fell in June, but remains above the “expansion” level of 50. June’s level of 53.8, leads me to believe that the U.S. economy will contract in the third quarter… But that’s just my humble opinion!

“This ‘unwinding of the carry trade’ continues to change almost daily… One day taking on risk is fine… And the next day it’s not. So, there’s just no ‘real’ trend, like I was hoping for a few days ago. But… We have to be ready for the eventual unwinding of the carry trade.

“The European Central Bank (ECB) ministers will meet today before heading to the beaches for their annual August holiday. While I don’t believe they will throw a grenade from left field with a rate hike before they walk out the door… I do believe they will set up the markets for a September meeting rate hike. So, look for the ‘vigilant’ word to be used today. That has been the wink and nod to the markets that a rate hike is coming in the past.”

Yes, the ECB meets today, and will likely follow the BOE who announced no rate cut this morning, but is leaning toward another in September. The Bank of England was first out of the interest rate announcement gate this morning and, as predicted, kept its benchmark interest rate at a six-year high. The nine policy makers said at July’s meeting that they would wait for new inflation and growth forecasts due out later this month before deciding whether further moves are needed.

They got one small piece of this data this morning as U.K. house prices rose at the fastest pace in three months in July. The average cost of a home in Britain rose 0.7% last month compared with 0.4% in June. Prices have increased 11.2% in the three months through July from a year earlier, the fastest annual pace since February 2005. Housing is proving to be a tough nut to crack for the BOE, and the continued strength will put pressure on policy makers to increase rates again in September. The economy has shown few signs of cooling. Inflation was 2.4% in July after reaching a decade high of 3.1% in March. Economic growth accelerated to 0.8% in the second quarter from 0.7% in the previous three months. I would look for at least one more rate increase in the coming months, which should give support to the pound sterling (GBP).

The European Central Bank will also probably leave its benchmark interest rate at a six-year high today. ECB President Trichet will hold a press conference today in Frankfurt later this morning. Trichet has typically signaled plans to increase borrowing costs one month in advance by pledging to show, “strong vigilance” on inflation. The recent credit market tightening in the United States won’t change the path of interest rates in the euro region, as Trichet will likely signal a September increase. While inflation has held below the ECB’s 2% ceiling for 11 straight months, the bank expects an acceleration beyond its comfort zone later this year.

While the dollar has been little changed versus most of the currencies this week, the interest rate differentials will come back into focus after these rate announcements and the dollar will likely start back on its slow slide down. Central banks around the world are raising rates to tackle the threat of accelerating inflation. We have seen recent increases by New Zealand and Canada, and expect the Bank of Japan to move its rate up. By contrast, the U.S. Federal Reserve has kept its benchmark rate unchanged, and the housing meltdown will prevent them from raising them well into 2008. The rate differentials will continue to put downward pressure on the dollar.

Speaking of housing meltdown, did you see the latest news on the victims of the subprime rout? AIG, the world’s largest insurer, is supposedly sitting on as much as $2.3 billion of losses from securities backed by subprime mortgages. But the news (and the losses) didn’t stop there. Addison Wiggin reported the following in Agora Financials 5 Minute Forecast:

“American Home Mortgage Investment Corp. announced yesterday that it can no longer fund home loans and is considering selling off all its assets. Once hailed as an innovator, the mortgage initiator told the press that lenders have simply cut off credit supplies, and that American Home has ‘substantial’ unpaid margin calls pending to lenders.

“On the news, American Home stock executed a lovely swan dive. American Home traded as high as $36 only eight months ago. It can now be yours for about a buck.

“Two Macquarie Bank funds have also warned investors that they’re feeling the flames of the meltdown. The Australian bank admitted that the Macquarie Fortress Fund and Fortress Notes fund were highly exposed to the CDO fiasco, and could stand to lose 25% of their value. About $300 million in investor equity.

“Macquarie shares fell 10% on the news.

“Bear Stearns revealed yesterday that yet another of its funds is overexposed. The $900 million Bear Stearns Asset-Backed Securities Fund has forbidden investors to withdraw their money as fund quants attempt to calculate its ‘value.’ Last time B.S. did this, the luckiest investors walked away with 91% losses.

“And shareholders of Sowood, the private investment firm, can look forward to much of the same this week. Sowood announced yesterday that two of its funds have lost over half of all their capital in July – at least $1 billion.

“‘We are very sorry this has happened,’ Sowood founder Jeff Larson wrote in the letter. ‘A loss of this magnitude in such a short period is as devastating to us as it is to you.’

“Sowood sold all of its $1.5 billion in assets to Citadel to cover the funds margin calls.

“But don’t worry, everyone, Treasury Secretary Paulson says everything is just fine. ‘I see the underlying economy as being very healthy,’ said Paulson as he left for China today.

“According to Hank, the U.S. subprime mortgage fallout is largely contained.”

Addison has a great writing style, and sheds a light on many subjects which the mainstream media would rather not show you. You can view his most recent report at

The yen (JPY) has been one of the best performing currencies this week as volatility in the markets has forced some investors out of their carry trade positions. Concern over the subprime market has caused a re-pricing of risk and a reversal of the carry trade. The yen gained as much as 1% during Asian trading and has appreciated 5.3% since June 22.

The yen carry trade was a topic of discussion at a meeting of Asia-Pacific finance ministers (APEC), which is taking place in Australia. Japan’s Finance Minister Koji Omi said, “It was pointed out that we’re experiencing a problem of one way movements. These movements aren’t desirable and future movements should be watched very closely.” Oh sure, now that the yen has started moving back up the Japanese finance minister wants to watch the movements very closely. Where was he when the yen was falling like a rock? This APEC is just another boondoggle, so don’t look for any coordinated response from those attending. The markets will take care of the value of the yen, as the carry trade looks to continue to reverse and the Japanese yen will continue to increase. I look for the yen and Swiss franc (CHF) to continue to out perform most other currencies over the next few months.

As I said earlier, the currency markets are largely unchanged today waiting for the ECB announcement and the jobs data in the United States. I don’t look for the employment data to give the U.S. dollar any strength, as the numbers will likely show Initial Jobless Claims remained above 300K. We will also see factory orders which are expected to have increased 1% in June on the back of stronger sales by Boeing.

Currencies today: A$ .8566, kiwi .7657, C$ .9451, euro 1.3662, sterling 2.0313, Swiss .8276, ISK 62.57, rand 7.094, krone 5.832, SEK 6.7527, forint 183.73, zloty 2.7719, koruna 20.53, yen 119.24, sing 1.5176, HKD 7.8291, INR 40.4225, China 7.5738, pesos 10.9250, dollar index 80.87, Silver $13.005, and Gold… $666.20

That’s it for today…Had a great night visiting with Chuck and his family last night. His daughter Dawn and her husband Jerry came by to visit and told me they will be going to the hospital on Friday (if not before) to have the baby. So Chuck will be a grandpa by sometime tomorrow! Good luck to both Dawn and Jerry!! Hope everyone has a great Thursday.

Chris Gaffney
August 2, 2007

The Daily Reckoning