Thin Trading Brings Tight Ranges

We had a pretty quiet 24 hours in the currency markets, with the majors all trading in a very narrow band versus the US dollar. We will probably have a few more of these days during the next two weeks, as currency desks are manned by the backups and trading thins out. Many of the institutional investors will be moving to cash in order to preserve gains for their year-end statements, and individual investors will have the holidays to take them away from the markets. Occasionally we will get a rogue piece of economic data which shoves the market one way or the other, but we typically won’t see any long-term positions being put on during the last two weeks of the year.

Thursday started out with more dollar strength as investors continued to take off risk positions, exiting the higher yielding currencies and moving funds into the US dollar. I read a story this morning on Bloomberg that confirmed my thoughts in the first paragraph. Bill Gross, who runs PIMCO, cut holdings of government debt and boosted cash to the highest overall levels since the collapse of Lehman Brothers in September of 2008. Gross increased the funds cash holdings to 7% in November from -7% in October. Readers may be questioning how a fund can hold negative cash; they accomplish this through leverage. I wrote a bit about the carry trade yesterday, and how investors were moving back out of this leveraged position, and the interview with Gross confirms my belief that the carry trade reversal is what has been strengthening the US dollar.

Investors have been scared out of these leveraged trades, with the debt problems in Greece and Dubai and the thought that the US Fed may be starting to look for an exit from their quantitative easing. As the economies of Asia continue to recover, inflation has started to appear back on investors’ radars. While Bernanke did his best to convince the market that rates would stay low for an extended period, he confirmed that the Fed would let the stimulus programs expire as originally planned on February 1 of next year. So while official interest rates will continue to be held at their extremely low levels, the Fed will begin to move toward the exits and try to pull liquidity out of the markets.

The FOMC has been faced with several reports suggesting that growth in the US is picking up. Retail sales climbed in November and inventories rose in October for the first time since August 2008. Exports have also picked up as a weaker dollar has started to work on balancing our lopsided trade picture. Yesterday we saw the leading economic indicators in the US climb 0.9% which was above forecasts. Manufacturing in the Philadelphia region (exports were helped by a weaker dollar) rose at the fastest pace in more than four years according to another report released yesterday. This data had some economists predicting the Fed would start raising rates in early 2010.

But I believe stubborn employment data will keep the Fed from increasing rates until late in 2010 (if then). The weekly jobless report put a damper on the rate hike crowd as it showed 480,000 initial job claims filed during the second week of December. This was an increase of 7,000 from the previous week, the second consecutive week that claims have climbed. Continuing claims have also pointed to a deteriorating employment picture. So we are currently having a ‘jobless recovery’ which doesn’t feel much like a recovery to the folks on Main street. With unemployment staying in double digits, the FOMC will face pressure to keep the stimulus in place longer than they probably should. While 2009 was all about rescues, 2010 is going to find central banks searching for the exits.

It looks like Ben Bernanke will be the one leading the search for the exits here in the US. The Senate banking committee voted 16-7 to recommend Bernanke’s nomination for another term as Fed Chairman. Democrats on the committee praised Bernanke’s emergency actions, which they said saved the economy from a more severe recession. The Senate will likely follow the committee’s recommendation, and Bernanke will serve for another four years. I’m sure his buddies on Wall Street were thrilled!

Moving across the ‘pond’, data released yesterday in Europe showed that Ireland’s economy exited the recession in the third quarter. GDP in Ireland rose 0.3% in the third quarter, marking the technical end of the recession. Germany and France exited their respective recessions in the second quarter thanks in part to government stimulus measures. Ireland still faces many problems, as the debt to GDP measure is worrisome, and their credit ratings are at risk. Greece has focused attention on this problem, but Ireland now looks like it is moving toward a sustainable recovery.

Other data released in Europe showed that German Business confidence rose to the highest levels in 17 months as exports help push manufacturing growth. The global recovery has helped German exporters sell their goods into the growing markets of China and India. The Bundesbank raised its forecast for 2010 growth earlier this week, and the data puts a positive end to the year. In contrast, French business confidence fell in December for the first time in nine months. While France’s expansion is set to continue, a large part of consumer spending has been tied to tax cuts and government incentives; so executives are less optimistic about demand going forward.

A story that ran in Bloomberg yesterday showed the Swiss franc (CHF) had moved past an important level versus the euro (EUR) yesterday. While we typically don’t track cross currency rates, and usually just follow the currencies versus the US dollar, this caught my attention as it showed the Swiss National Bank may be moving away from their hard line against further franc appreciation. The SNB had been intervening in the markets to keep the franc’s value down versus the euro and US dollar. The failure of the SNB to act yesterday indicates that they may be throwing in the towel and will stop intervening. If this is true, the Swiss could see a nice appreciation versus the euro and US dollar.

The two biggest losers versus the US dollar over the past 24 hours have been the Japanese yen (JPY) and Brazilian real (BRL). These certainly make strange bedfellows, as they are opposite sides of the carry trade. Brazil boasts some of the highest interest rates, while Japan has near zero rates and is typically the currency of choice for funding these carry trades. The Japanese yen fell after the Bank of Japan said it wouldn’t tolerate price declines and will likely keep rates near zero to combat deflation. The Japanese continue to battle deflation even as their economy seems to be picking up steam. The BOJ Governor indicated overnight that he’s prepared to expand monetary easing (r.e. quantitative easing) should a rising yen and deflation threaten the recovery.

Brazil’s currency fell in spite of some good economic data. Brazil’s unemployment rate fell for a third month to the lowest level of 2009. Latin America’s biggest economy expanded 1.3% in the third quarter and is expected to grow 5% next year. Some of the selling of the real was probably due to a speech given by NY Professor Nouriel Roubini. Roubini said Brazil’s currency is overvalued, and that the economy would fail to grow faster than 4.5% without the help of new legislation. I am usually in agreement with Mr. Roubini, but have to disagree with his thoughts on this one. While the real has certainly appreciated dramatically, this is an emerging market, and their ties to the world’s largest consumer of commodities (China) should propel their economy in 2010. The currency has dropped to the lowest level in 11 weeks, and is starting to get to levels that look like an excellent buying opportunity.

To recap: Thin trading brings tight ranges, carry trades are reversing, another four years for Bernanke, mixed data out of Europe, and the Japanese yen and Brazilian real move in the same direction versus the US dollar.

The Daily Reckoning