U.S. Consumers Come to the Rescue of the Dollar

Good day… The dollar bulls took control of the currency markets yesterday after the U.S. consumer confidence numbers looked slightly less awful than expected. The better-than-expected confidence number caused the dollar to jump over one and a half cents versus the euro (EUR) and close to 1% versus the New Zealand dollar (NZD). The gain by the U.S. dollar was the biggest one-day move in almost two months.

Chuck, who is enjoying a much-deserved break this week, sent me his thoughts on this dramatic move by the dollar:

“Once again, it sure looks like the markets took the bait hook, line and sinker yesterday. I mean, consumer confidence rises from a deep dark abyss, and the markets were singing, ‘Ding, dong the witch is dead, ding dong the wicked witch is dead.’ The wicked witch here is the bear and what it’s done to the markets this year. Since November, stocks have lost plenty of ground, and I for one truly suspect there will be more losses in the days ahead. But… Not yesterday, and not a losing day for the dollar either! Probably the best 1-day performance I’ve seen in the dollar in some time.

“Again, though, I just have to believe this is a bear trap… And one that will take no prisoners once it gets sprung! The housing data yesterday was awful. But get this… One headline said, “Not as awful as expected”. So, that’s a reason to celebrate with a rally? Has this whole world gone mad? I sure am glad I’m on stay-cation, and not following all of this! HA!”

All of us on the trade desk were as confused as Chuck yesterday, after U.S. confidence numbers came out. None of us could figure out just whom the pollsters were interviewing, so we started asking callers how confident they were in the U.S. economy. Granted, our callers are probably a little more pessimistic than most (I like to call them realists!!) but still, not one of our callers yesterday thought that the U.S. economy is better today than it was a month ago.

One explanation for the increase in confidence could be that consumers are still feeling good from the quick hit of the stimulus checks. Another reason for optimism could be the recent 16% slump in oil prices in the past two weeks. It is interesting to note that in the past year, the euro-dollar exchange rate and oil have had a correlation of 0.9 according to Bloomberg calculations based on the correlation of their value changes. A reading of 1 would mean they moved in lockstep. This drop in the price of oil is also credited with helping to drive the U.S. stock market higher. So falling oil prices and rising stock prices have combined to help boost the value of the U.S. dollar.

But the question is how long will these two factors remain positive? A story that I read this morning on Reuters warns investors not to confuse a healthy correction for the end of a multi-year bull trend. The story points to bullish long-term structural issues, such as growing Asian demand and lackluster non-OPEC supply growth. Even if we see a pull back to $100, most don’t think it will mean that the long-term bull trend will be finished. And none of the information I am reading believes oil will fall below $100 anytime soon. Granted, $100 per barrel is better than $150 per barrel, but it is still going to crimp the pocketbooks of consumers.

Another question I am asking myself this morning is what underlying economic fundamentals here in the United Sates have improved over the past few weeks? Two different reports by the International Monetary Fund released this week point out that there is no end in sight to the credit crisis and U.S. housing slump. The fund warned that credit growth in the United States could fall further as a result of ongoing financial system stress. The IMF reaffirmed its controversial earlier estimate that losses in this cycle could total $945 billion – a number that combines mark-to-market losses on subprime-related securities and estimates of likely losses on loans.

And according to Pimco’s Bill Gross, manager of the world’s biggest bond fund, this number is probably conservative. In commentary posted on his firms website, Gross said falling home prices will force financial firms to write down $1 trillion from their balance sheets. About 25 million U.S. homes are at risk of negative equity, which could lead to more foreclosures and a further drop in prices, he said.

I agree with both Gross and the IMF. There’s no end in sight to the U.S. housing recession and deteriorating credit conditions for consumers and banks will definitely prolong a period of slow economic growth. I believe the best way for investors to withstand this economic storm is through proper diversification of their assets. Both currencies and precious metals should be a part of your portfolio in order to protect your purchasing power. Don’t be fooled by the latest rally in the stock market; unfortunately, the bad times aren’t over yet.

But the markets have a shorter-term outlook lately, and as I reported earlier, the dollar rallied on the back of the increase in U.S. consumer confidence. This latest data has many economists and ‘experts’ predicting the worst is over. As you can see, I don’t agree with this thought, and I hope pfennig readers are able to see past one piece of questionable data.

Data released this morning in Europe fueled the dollar rally even further. Europeans’ confidence in the outlook for the economy dropped the most since the September 11 terrorist attacks, as soaring energy costs and the euro’s advance against the dollar rattled consumers and executives. Rising commodity prices have lifted the euro-area inflation to a 16-year high, sapping consumers’ purchasing power and pushing up companies’ costs. European retail sales, also reported this morning, fell for a second month in July. Unlike their counterparts here in the United States, European consumers have pulled in the reigns on spending in the face of a global slowdown.

In spite of these poor numbers, the ECB will continue to focus on the higher inflation numbers and keep a hawkish stance on interest rates. While they will have to weather some criticism in the short-term, I think time will prove that the ECB is correct in maintaining their fight against inflation. The value of the euro will be maintained, as the ECB keeps up their vigil.

The contest to see who can report the worst economic numbers continued, as Switzerland’s leading economic indicators fell more than expected to the lowest level in almost five years this month. Switzerland’s expansion is losing steam as a U.S. led global slowdown and soaring raw material costs cut into earnings of Swiss companies. But as the fastest inflation in 15 years weighs on spending, the central bank will have limited room to lower borrowing costs. I expect the Swiss central bank to follow the lead of the ECB, maintaining their interest rates and supporting the Swiss franc (CHF).

Japan jumped on the bandwagon of negative reports as industrial production fell last month for the first time in four years. Factory output dropped 2% from May, when it rose 2.8%, the Trade Ministry said today in Tokyo. The yen (JPY) continues to be sold and fell through the 108 handle overnight. But economic fundamentals are not the only driver of the Japanese yen. As readers know, the carry trade is a dominant player in the value of the yen. As volatility increases, the carry trade will likely be reversed which should cause another jump in the value of the yen in spite of the negative economic outlook.

The biggest loser versus the U.S. dollar yesterday was the New Zealand dollar, which extended its recent decline. Reserve Bank Governor Alan Bollard said New Zealand’s slowing economy would ease inflation over the next two years, justifying further rate cuts. “Our judgment is that the weakness in the economy will be sufficient to bring inflation and inflation expectations down over the medium term,” he said in a speech in Auckland. “We have thus adopted an easing bias in our monetary policy.” As Chuck pointed out last week, many investors flocked to the kiwi chasing the higher yields, so these signals that interest rates will be dropping have caused these investors to exit the currency. With Bollard definitely signaling a change in policy, we will likely see a further decline in the value of the kiwi.

The bad news flowing out of New Zealand also impacted its kissing cousin across the Tasman. Australia’s dollar (AUD) fell to a six-week low as a government report showed that home building approvals unexpectedly dropped in June. With Bollard signaling further cuts in rates, currency traders have begun to predict that Australia will follow suit. But I disagree. The Reserve Bank of Australia didn’t raise rates as high as New Zealand’s central bank, and therefore have less room to lower them. Ongoing demand out of Asia will continue to keep commodity prices up, and support the Aussie dollar.

I will try to end this somewhat negative Pfennig on a positive note. Many of you are probably wondering just where to turn for your next investment. I still believe the Swiss franc, Australian dollar, and Asian currencies hold long-term value. Another currency that we have been a fan of is the Norwegian krone (NOK), and Goldman Sachs agrees. Norway’s krone will rise as energy prices and the prospect of further interest rate increases by the Norges Bank support the oil producing nation’s currency, according to a research report by Goldman Sachs Group, Inc. Norway’s central bank raised its benchmark rate twice this year to keep inflation below its target. Oil at current levels would generate additional revenue of $40 billion or 6% of gross domestic product according to Goldman’s research. These fundamentals should ultimately drive the krone up versus the U.S. dollar. We continue to suggest additional investments in this currency.

Currencies today 7/30/08… A$ .9473, kiwi .7331, C$.977, euro 1.5584, sterling 1.9793, Swiss .9551, ISK 79.99, rand 7.4083, krone 5.1630, SEK 6.0702, forint 148.57, zloty 2.0835, koruna 15.32, yen 107.77, baht 33.48, sing 1.3688, HKD 7.8032, INR 42.41, China 6.8273, pesos 10.05, BRL 1.5686, dollar index 73.25, Oil $121.72, Silver $17.11, and Gold… $908.05

That’s it for today… I sound pretty negative this morning, but the data being released shows the world’s economy is slowing. So where can investors turn? As I said earlier, portfolio diversification is the key. Look at these short term ‘sucker rallies’ in the dollar as buying opportunities. Purchase currencies that have strong economic fundamentals, and over the long term you should see nice returns. Hope everyone has a wonderful Wednesday!

Chris Gaffney
July 30, 2008