US Borrow and Spend Policies Continue

What a day it was in the currency markets on Tuesday! The rout on the dollar continued, and was broad-based with gains in every currency we trade. The commodity-based currencies led the pack, as the weaker dollar fueled a big run-up in raw material prices. Reports out of both Asia and Europe signaled that the global economy is recovering, and that bolstered investors are looking for a way out of the falling dollar.

European industrial output rose for a fourth month in August, increasing just below 1% from July. From a year earlier, August output fell 15.4%, a big drop but still the smallest YOY decline in eight months. The euro (EUR) area continues to recover ‘at a gradual pace’ according to ECB President Trichet. The positive news coming from the manufacturing sector is a good sign the European economic recovery will be sustainable.

Another report overnight showed that China’s exports fell by the least amount in nine months during September. As we have written over and over again, China will lead the world out of the global recession, and the latest reports show China beginning to pull away. Reports due out next week will likely show that China’s economic growth accelerated to 8.9% in the third quarter, slightly above the government’s target.

China has used the economic downturn to lock in a dominant position in world trade, and has replaced Germany as the world’s biggest exporter. During the first seven months of this year, China has moved past Canada as the number one supplier of imported goods to the US with 19% of all imports entering the US originating in China. These exports continue to bolster China’s foreign reserves, which climbed $141 billion in the third quarter to a record $2.273 trillion. China has decided to keep their currency pegged to the falling dollar, which has helped them increase their exports leading to additional growth in their currency reserves.

The Chinese government is now looking to leverage their huge reserves to attain a more dominant role in the post-crisis global financial order. A story in the China Daily predicted Bank of China Vice-President Zhu Min would soon take up a crucial post at the International Monetary Fund (IMF). According to the Chinese paper, “Zhu’s appointment at the IMF will be a significant step toward breaking up the US and Europe’s dominant position in the international financial stage”. Welcome to the new world order!

Today we will finally get some data in the US, with the release of retail sales, business inventories, and the monthly budget statement. We will also get to read the minutes of the Sept 23rd FOMC meeting, this afternoon. Retail sales is the number to watch, and it is expected to have dropped by over 2% with the end of the ‘cash for clunkers’ program. If the data come in as expected, it will confirm that the US consumer will not be able to sustain their spending as the government stimulus fades. So while Europe and China look to be expanding, the US is bogged down with rising unemployment and weak growth.

I can pretty much predict what the administration will say after seeing the report: It is obvious that we need to have another stimulus package!! The administration thinks the way out of this mess is to borrow and spend, and if the US consumers won’t do it on their own, the government will be more than happy to spend our money for us. But President Obama’s effort to spend us out of recession is undermining the US dollar. In spite of his pledge to keep the dollar strong, the dollar index is down 10% during the first 8 1/2 months of Treasury Secretary Tim Geithner’s term.

And the boys over at the Federal Reserve certainly don’t seem like they want a strong dollar either. Fed Vice Chairman Donald Kohn put a shot across the dollar’s bow yesterday when he said interest rates would remain low for an ‘extended period’. I expect the minutes of the FOMC meeting – released later today – will show the members continue to focus on the short-term and have turned a blind eye to the threat of future inflation. The dovish tone that the Fed has taken will continue to push the dollar lower.

I read the following quote in an article on Bloomberg that I thought was dead on: “The all night printing runs at the Treasury are chipping away at the dollar’s ability to hold value compared to other currencies and commodities,” Mike Sander, of Sander Capital said yesterday. “With dollar weakness, inflation fears, a huge budget deficit, energy prices creeping up, metals such as gold, silver, and copper will be pushed up in price.” Sounds like Mr. Sander is a Pfennig reader!!

As I pointed out in my opening paragraph, commodity prices have surged on the positive economic news from China and Europe. Demand by China continues to support the market for raw materials, and a falling dollar has created additional demand. The prices of oil, gold, and copper all moved higher yesterday and brought the currencies of Canada (CAD), South Africa (ZAR), and Norway (NOK) along for the ride. The South African Rand and Norwegian Krone were both up nearly 1% versus the US dollar, and the Canadian loonie moved a bit closer to parity. Norway’s finance minister helped push the krone higher with the announcement that their stimulus efforts will generate an extra 0.5% of economic growth next year. The Norges Bank considered moving interest rates higher last month, and looks poised to deliver a rate increase at their next meeting.

I know I will get some emails accusing me of being hypocritical, bashing the US and UK stimulus plans while praising those of Norway and China. The big difference between these plans is that Norway and China are spending money they already have, while the US and the UK are borrowing in order to spend. Norway is spending some of its $450 billion oil fund in order to stimulate their economy, and China has been spending some of their record reserves. These stimulus plans will be less inflationary than the ‘quantitative easing’ being instituted by the US and UK.

Gold benefited from the good economic news and a push by investors to diversify out of US dollar holdings. Gold advanced to a record level for a second day as investors increased purchases in order to hedge against a falling dollar and the possibility of future inflation. A report I read this morning predicts further price gains by gold: “A weakening US dollar and easy liquidity conditions will particularly favor precious metals,” Morgan Stanley analysts said in a report today. “We expect prices of gold, silver, and platinum all to register further gains over the next year.” Gold at $1,100 looks like a done deal in the face of increased investor appetite for dollar alternatives.

The Daily Reckoning