Trade Gap Shrinks Thanks to the U.S. Dollar

Good day… The dollar stopped climbing yesterday, but didn’t give much of its gains back, as the U.S. data provided support for the dollar bulls. Today we will get some data that will probably be less supportive, so I would expect to see the dollar lose some of its recent strength. I don’t expect any major moves, with the dollar staying in a fairly tight range; but any tests of the range will be on the downside for the dollar.

We had the release of two fairly major pieces of data here in the United States yesterday, and both surprised on the positive side for the dollar. The U.S. current account deficit narrowed in the third quarter to $178.5 billion, the smallest in two years, as the trade gap shrank and Americans earned more on overseas investments. The shortfall was less than expected and followed a revised $188.9 billion gap in the second quarter, the Commerce Department said yesterday. The dramatic drop in the dollar throughout most of 2007 was the main reason for this improvement in the current account shortfall.

This shrinking trade gap is exactly what the Fed has been wanting to see, as the weaker dollar has helped exports. The U.S. dollar dropped 2.6% in October, the biggest monthly decline since May 2006. The economies of the rest of the world are growing faster than the U.S. economy, which has increased demand for our exports, while U.S. imports (with the exception of oil) have slowed. The U.S. economy is predicted to grow 2.3% in 2008 while the euro-zone economy is expected to grow 2.6% and China will probably expand 11%.

Net exports added 1.37 percentage points to the third quarter U.S. growth, the most since 1996. “For the first time in many years, the trade sector has been a positive contribution to the U.S. growth as opposed to a negative contribution,” Fed Chairman Ben S. Bernanke said in congressional testimony November eighth. “I think going forward we’ll see additional strength coming from foreign trade.” Does this sound like someone who is pursuing a ‘strong dollar policy’? I think we all know this administration’s strong dollar policy is a complete farce. They are happy with the overall effects of the weaker U.S. dollar, and will continue to let the dollar slip in order to improve our trade deficits. The dollar dropped 2.6% in October, the biggest monthly decline since May 2006.

The gap amounted to 5.1% of the economy – the least since the first three months of 2004, compared with 5.5% in the second quarter. While this number is a definite improvement, it still demands that we attract just under $2 billion a day to fund the gap.

This brings us to the second set of data, which was released yesterday – the Net Long-term TIC flows. International buying of U.S. financial assets increased by a net $114 billion in October, the most in five months, according to a separate report from the Treasury department. Overseas demand for American stocks and bonds has rebounded after credit-market turmoil contributed to record sales of long term assets in August.

But many question whether this one month of data can be the sign of a true turn around. Prior to this summer, net inflows were around $100 billion or just above. Things slipped badly in August and most assumed that inflows would recover to the $50-100 billion range. But I doubt if net inflows will be able to bounce back up to $100 billion plus and stay there. The deepening economic gloom in the United States and growing credit losses suggest that a sustained bounce-back is questionable. I am from the ‘show me state’ so I will wait to see what the coming months bring us.

My pessimism is shared by some pretty astute analysts. Goldman Sachs, one of the only NY investment banks to report a record profit in 2007, had this to say about the data in a report yesterday afternoon: “The good news is that the US current account deficit shrank in Q3 and that investors seemed to regain some confidence in US bonds and stocks in October. The bad news, in our view, is that the funding of the currency account deficit looks a bit suspect and overseas investors could easily get cold feet about US stocks and bonds again. This leaves us feeling that the dollar is still batting on a very sticky wicket indeed. What’s more, with the dollar becoming more undervalued all the time against currencies like the euro, the recent slide in the single currency leaves us feeling that it’s a lot easier to recommend buying the euro in the low $1.40s than it was close to $1.50 last month. Our target for the euro next year is $1.55, but it could go higher, while we think dollar/yen will slide to 100 yen/$ and the Swiss franc should hit parity.”

The report went on to say that the financing of the deficit is coming increasingly via a rise in the ‘errors and omissions’ account. “In Q3 the surplus here was $85.6 billion, or over twice the $36.7 billion seen in Q2. When you consider that, in 2006, this account was in deficit to the tune of $17.8 billion, the turnaround has been quite significant… Now what goes into the errors and omissions (or ‘statistical discrepancy’ as the US Bureau of Economic Analysis describe it) by be [sic] good capital flows. But we are a bit skeptical.” This certainly smells of creative accounting!

But the markets liked the positive data, and the dollar retained earlier gains after the report. The euro (EUR) fell to below $1.44 but has rallied back above this morning. Money market rates in Europe tumbled this morning after the ECB injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit markets. The ECB wants to make sure the markets know they’re seriously committed to restoring faith in the interbank market. While they have been willing to inject short-term cash, they are still talking hawkish when it comes to inflation. These short-term loans will be temporary, and interest rate cuts still don’t seem to be on their agenda. I would expect to see the euro bounce back up with these sub 1.44 levels being viewed as some excellent buying opportunities.

Two currencies that started to rebound versus the U.S. dollar yesterday were the Aussie dollar (AUD) and New Zealand dollar (NZD). Both benefited from a general move back into the ‘carry trade’. Australia’s dollar was the biggest gainer versus the yen (JPY), which helped it advance from near a three-month low against the U.S. dollar. Australia’s dollar was boosted after the Reserve Bank of Australia released the minutes of its December 4 policy meeting, showing that board members decided against raising the benchmark rate two weeks ago because the global credit rout had already increased the cost of lending. “Members indicated that, absent the changes in the market yields since the November meeting, there would have been a strong case on domestic grounds for a rise in the cash rate at this meeting,” the RBA said. Sounds like they are still looking to raise rates, which will support the Aussie dollar going forward.

Today we will see data on the state of the U.S. housing markets with the release of housing starts and building permits for November. Neither of these numbers are expected to show much of a rebound for the U.S. housing industry. Housing will continue to be a drag on the U.S. economy well into 2008. But this bad news has already been priced into the markets, so I would expect the dollar to remain in a range through most of the day.

Currencies today: A$ .8626, kiwi .7570, C$ .9930, euro 1.4401, sterling 2.0152, Swiss .8679, ISK 62.95, rand 6.9160, krone 5.5838, SEK 6.5579, forint 176.06, zloty 2.51, koruna 18.3015, yen 113.47, baht 30.59, sing 1.4598, HKD 7.8012, INR 39.565, China 7.3796, pesos 10.8545, BRL 1.8115, dollar index 77.401, Oil $91.51, Silver $14.01, and Gold… $799.55

That’s it for today… We continue to be very busy on the desk, but Ty is back from his soccer tournament in Mexico so we will almost be back to full staff for a few days! We are supposed to see temperatures back above 40 degrees today, so we will have to say goodbye to our blanket of white snow. Looks like we won’t have a White Christmas after all. Hope everyone has a Terrific Tuesday!

Chris Gaffney
December 18, 2007

The Daily Reckoning