US Data Drag Down the Dollar

We had a pretty volatile trading day yesterday, with the dollar falling dramatically in early trading but climbing back up through most of the afternoon. Overnight trading has been choppy, and the dollar is trading pretty much right where it was when I headed home last night. It was the volatile Empire Manufacturing data that sent the dollar into a tailspin yesterday morning. An index of manufacturing in the New York region was cut nearly in half, falling from 21.70 in April to a measure of just 11.88 in May. This number is traditionally very volatile, so it shouldn’t have any long-term impact, but it did set the markets in a ‘sell dollar’ mode which continued when the Net TIC flows were released 30 minutes later.

Global demand for US long-term financial assets such as government bonds slowed in March as investors shortened up their maturities and China trimmed their portfolio of US Treasuries. The total TIC flows were up at $116 billion in March versus $95.6 billion the month before. But the makeup of these purchases is what is concerning. Foreigners decreased their net long term TIC flows from an adjusted $27.2 billion February to $24 billion in March. This figure is a good gauge on international confidence in the US economy and foreigners seem to be getting more concerned over the inflation prospects in the US, and perhaps worry about our ability to pay down our long term debt. Investors typically shift to the shorter end of the curve when they are concerned about inflation, or in volatile times when they just want to ‘hide’ from market volatility. Both combined to push investors away from the longer dated maturities and into the short term US Treasury bills.

The problem this creates for the US is two-fold. First, with fewer buyers of the longer dated maturities, interest rates on these securities will be forced up. Right now the Treasury has been able to hold longer-term rates down with the bond buying of QE2, but what happens when that program is scheduled to end? The lack of buying interest in our longer term securities could push interest rates dramatically higher after QE2, and help force another round of quantitative easing (this is the vicious circle that Chuck has been warning readers about).

The second problem with the shortening of maturities is that the US will have to roll that debt in the coming months and years, and with global interest rates on an increasing path, our debt will get less and less attractive to these foreign investors. In order to attract these buyers, rates will have to go higher. These higher rates will increase the already skyrocketing debt burden on the US, as interest payments will be forced up along with the rates offered to foreign investors. More and more of our budget will be used to pay these foreign bondholders, and our debt hole will continue to get deeper.

China is the biggest foreign owner of US Treasuries (our own Federal Reserve is now the largest holder of our debt!!) and they have been trimming their holdings. Figures released yesterday show China now owns $1.145 trillion of the debt, which is down $9 billion from their holdings as of February. The holdings had reached a record of $1.175 trillion in October of last year. China has been vocal about their concerns regarding the growing debt burden of the US, and the amount of new debt the Treasury department continues to add. According to many with knowledge of China’s central bank, the amount of US Treasuries in China’s investment portfolio will be gradually cut and the funds diversified into other currencies and fixed income securities. This is not good news for the US dollar or debt situation.

We will get another round of data on the state of the US housing market this morning. The housing downturn is kind of old news by now, but construction is still one of the drivers of the US economy, and housing continues to be a drag. Housing starts are expected to have increased slightly from last month’s 549K, and building permits are projected to have remained flat. The problem with the housing market is that the banks that now own many of the ‘available’ homes are slowly releasing them back into the market. As they put these foreclosed homes back into the market, they free up capacity to start the foreclosure proceedings on additional homes. There is still a huge glut of supply, both in the market and ‘waiting in the wings’, so I don’t expect our housing downturn to reverse for some time.

An agreement was reached by European financial chiefs without the help of the IMF leader who is spending some time on Rikers Island. But the bailout wasn’t for Greece; but instead, a 76 billion euro package was given to Portugal. The finance chiefs want Greece to do more in order to win improved aid terms. Extra money for Greece will be tied to demands for deeper spending cuts and additional asset sales. The Greek government has been reticent to let go and privatize some of their best state assets, but the EU officials want to see more privatization in an effort to reduce the overall debt burden. The sale of the state assets will probably be an easier sell to the Greek citizens than additional spending cuts, but both will be needed in order for Greece to avoid default, and even with these efforts many believe default is inevitable. The euro (EUR) recovered one cent to top $1.42 in early European trading, and according to technical analysis, the $1.4121 is an area of support, with $1.3958 a major support level.

UK inflation rates accelerated to 4.5% in April to the fastest since October 2008, possibly forcing BOE Governor Mervyn King to explain publicly why officials haven’t raised interest rates yet. The pound (GBP) rose as investors felt that the BOE would now be force to push rates up at their next meeting. King did say inflation is likely to rise further in the coming months, but feels it will be easing back toward the bank’s 2% target next year.

Another central bank that is expected to be raising rates is the Reserve Bank of Australia. But interest rate increases aren’t the only tool Australia will be using to fight rising prices. Australia’s Treasury Secretary said the local currency would probably stay elevated ‘for some time’ helping to contain inflation. Singapore’s central bank has used the value of their currency as their main tool in combating inflation, and the idea seems to be growing in popularity. Countries such as Australia, Brazil, and Singapore have the advantage of a strong economy, which allows them to let their currencies rise without fear of the negative impact on exports. All three of these country’s currencies have been rising, and will probably continue as their central banks try to keep internal price pressures from overheating.

Australia and Brazil have been very volatile of late, as commodity prices continue to swing wildly. But Singapore hasn’t been subject to the same wild swings, and should be considered by investors as a good candidate for some Asian exposure. Singapore held an election on May 7th and the majority party lost some seats, but still held on to power. This was seen as a positive for the country, as the opposition voices have forced some changes and ‘soul searching’ on the part of the Prime Minister Lee Hsien Loong. But on the negative side, Mr. Loong’s party has done a very good job of running the country, which has seen an unprecedented string of growth while maintaining solid economic fundamentals.

Singapore’s retail sales unexpectedly rose 7% in March from a year earlier after dropping a revised 3.2% in February. Singapore’s unemployment rate is at a three-year low, and tourists from Asian and Europe are visiting the city in record numbers. As I mentioned earlier, Singapore is unique in that their central bank does not use interest rates to combat inflation, but instead lets the value of their currency appreciate to slow down their export driven economy. This is a big plus for currency investors, as global inflation continues to push the Singapore dollar higher. All indications are that Mr. Loong will be able to continue to encourage good growth while maintaining control of the money supply. Again, the Singapore dollar (SGD) is an excellent choice for those looking for alternatives to the slow and steady Chinese renminbi (CNY) or the very volatile (and currently overpriced) Japanese yen (JPY).

Both gold and silver dropped a bit yesterday, continuing the wild ride that they have been on lately. Gold is now trading well below $1,500 and silver is back to the mid $33 range. Investors who are getting tired of the constant swings in these precious metals may want to consider our latest MarketSafe CD, which was introduced by Chuck at the Global Currency Expo last weekend. The Timeless Metals MarketSafe CD has a 5-year term and the return is based on the performance of gold, silver, platinum, copper, and nickel. Additional information on our newest MarketSafe offering can be found on our website here.

To recap: US data showed NY manufacturing is down, and housing is expected to show additional drags on the economy. China is reducing the amount of debt they are buying, not a good sign when the US continues to run up huge deficits. The EU leaders bailed out Portugal, but want more from Greece before they restructure their debt. UK inflation rose, and may force rates higher. Singapore’s central bank continues to allow their currency to appreciate, and we introduced our latest MarketSafe CD based on metals.

Chris Gaffney
for The Daily Reckoning