US Dollar Rallies on Safe Haven Buying and EU Debt Crisis

Worries over the sovereign debt crisis have pushed investors out of the euro (EUR) and into the US dollar. The “risk” trades have been pulled off the table, and investors are seeking shelter in the relative safety of the dollar. I had a reader ask me what I was looking at on Friday when I wrote that the euro had ticked higher versus the US dollar. Apparently I need to remind everyone that I write this at around 5 AM, so when I talk about the euro moving higher, it is in the early European trading. On Friday, the early euro strength was quickly reversed as the US trading desks took the dollar higher.

The confidence instilled by the EU agreement on a permanent debt-crisis mechanism was quickly reversed as concerns over the Irish banking system, and upcoming Spanish debt refinancing pushed investors away from the euro. The ECB and BOE set up a temporary swap line to help ease liquidity pressures at Irish banks. The BOE approved up to 10 billion pounds to the ECB in exchange for euros if needed. These euros would then be made available to the central bank in Ireland, whose four largest lenders have UK units. This is a sign that England may be drawn into the sovereign debt crisis, which they have been able to avoid thus far. It is clear that the problems facing the Irish banking system aren’t over, even though the main focus has now shifted over to Spain and Portugal.

That is the problem with this European debt crisis. Bond vigilantes continue to just pick off the weakest of the pack, ganging up on whichever country has the next big refinancing. By shorting the bonds of these nations, yields are moved higher, raising their refinancing costs. This puts additional strain on already tight budgets, and moves these countries into crisis mode. The ECB is then forced to step in and provide liquidity to the markets, and the bond traders move on to the next country. Unfortunately this “game” looks like it will continue through most of 2011, keeping a lid on the upside of the euro.

Bond prices in the US have also been dropping as investors have increased their worries over the inflationary impacts of QE2. Yields on the US 10-year Treasury bond have risen dramatically in the past 30 days and are trading back near the levels we saw at the beginning of the year. If Bernanke wanted to push borrowing costs lower with QEII, they sure haven’t been successful. But the stock jockeys at CNBC sure don’t seem to mind the higher long-term rates. US stocks are up 17% since the Fed disclosed the QE2 package according to a story I read on Bloomberg this morning. It is now more than obvious who our Fed Chairman reports to, and it isn’t the US taxpayer, but instead his buddies on Wall Street. With QE2, Bernanke has sacrificed our future for some short-term gains in the equity markets.

These higher yields have been good for the dollar, giving investors a bit more yield while placing money into the US “safe haven.” A report Friday showing a sharp increase in US leading indicators helped propel the dollar higher. The Conference Board’s gauge rose 1.1% in November after a revised 0.4% gain in October. Former Fed Head, Alan Greenspan, certainly sounded upbeat regarding the US economic recovery during an interview on Friday. “The US economy unquestionably has some momentum,” he said in an interview in Washington. “The fourth quarter looks good. The growth rate could be 3.5% or more” for the final quarter of this year.

But workers outside of Wall Street and Washington are still searching for the positive impacts of QE and QE2. Payrolls decreased in 28 US states and the unemployment rate climbed in 21 during the month of November. A Labor Department report released in Washington on Friday showed that unemployment continues to rise in most areas of the US. Unemployment increased in November for the first time since August, which would seem to call into question the stock markets euphoria over QE2 and the extension of the Bush era tax cuts. While Greenspan and the folks on Wall Street don’t seem to mind, the reality of our mounting debt is starting to grab some attention in the mainstream media.

Chuck sent me the following late last night:

Well… Looky here! It only took 60 Minutes over one year to catch up with what I kept pointing out to you dear readers… That the US states are so far in debt, they can’t make payments, policemen can’t fill up their gas tanks, and pensions can’t be funded… The debt problem of our states is unsustainable… But… The media wants to focus on the debts of Greece? Ireland? Both of those two states together don’t stack up to California, which I might remind everyone IS the seventh largest economy in the WORLD!

I sat here watching and listening to these people on 60 Minutes… Saying… Yes, I told my readers that a year ago; yes, I told my readers that 6 months ago…and so on. But, maybe, with it being 60 Minutes, the markets will begin to take notice? Nah… I doubt people really watch 60 Minutes any longer… The only reason it was on at my house is that it came on right after the Steelers/Jets game!

The key here is that this is the next deficit shoe… A bailout that will have to come to market, and probably in 2011… So get prepared… Oh… And have a great day!

Chuck just can’t take a vacation from The Pfennig… The ideas just keep coming and he feels the need to share them with all of his readers!

I was doing a bit of reading this weekend and came across an article on Barron’s by Randall W. Forsyth which really does a great job of laying out what could end up being the biggest story of 2011… The beginning of the end of the US dollar as the world’s reserve currency. Just like the story on 60 Minutes, the Barron’s article is about a year behind our own Chuck Butler who has been telling Pfennig readers about the demise of the US dollar as the world’s reserve. But Mr. Forsyth’s article does an excellent job of laying out what has happened to the US dollar’s dominance during the past few years.

Because the rest of the world uses the dollar for transactions and a store of value, the US has been able to take advantage of that. Indeed, the greenback is America’s most successful export.

So, Americans get the goods, allowing us to consume more than we produce, simply because the rest of the world wants our paper. That fuels the US credit expansion that covers the gap between Americans’ savings and US investment, including for residential real estate. Without money from abroad, there would not have been the housing bubble. American ingenuity produced triple-A mortgage-backed out of subprime loans, which dollar holders around the globe eagerly scooped up.

He ends the article with another confirmation of what Chuck has been talking about in The Pfennig for a couple of years: the rise of the commodity currencies:

Seen from a historical perspective, if the 20th century was the American century, it would be natural that the dollar would the dominant currency. The 21st century is being called the Asian century. Brazil is part of that, now that China is its main trading partner, overtaking the US. So, too, is Australia, which is booming as a commodities supplier to Asia.

The demand for dollars from the rest of the world has been of inestimable benefit to the US economy. It quite simply allows Americans to consume more than they produce and save less than they invest; in other words, to live beyond our means. The dollar’s dominance will not be toppled in 2011 but will wane over the coming decade and beyond. And America will have to start picking up the tab for what had been a free lunch.

But for now, investors are focused on the problems in the Eurozone and have moved funds back into the US dollar. With risk trades being taken back off the table, the commodity currencies of Australia (AUD), South Africa (ZAR), and New Zealand (NZD) all traded lower. Rising US yields are also contributing to the reversal of these currencies versus the greenback. Yield differentials have been one of the driving forces for the currencies of Australia, South Africa, Brazil, and New Zealand. The minutes of Australia’s December meeting will be released tomorrow, and is expected to show that policymakers will not be increasing rates in Australia anytime soon. With US rates climbing and Australian rates remaining on hold, the Aussie dollar could struggle versus the greenback over the next few months.

The rally in the commodity currencies has been strong again during 2010, but several of the “experts” are now saying that the commodity currency rally is over. A story I read on Bloomberg this morning quotes traders from Deutsche Bank (the world’s largest currency trading desk), Barclay’s, and Goldman Sachs as saying that the commodity currencies are now overvalued according to purchasing power parity numbers. These traders say expected increases in commodity prices have already been factored into the values of these currencies, so they don’t expect another big rally for the Aussie and New Zealand dollars. I would just remind readers that PPP has shown that the US dollar has been undervalued versus the euro for over seven years, so the PPP isn’t what I would call a good indicator for a currency’s short (or even medium) term direction. The story quotes a few of the traders as saying the fundamentals of these countries are very good, but according to their PPP gauge the currencies are overvalued. I for one will stick with the fundamentals, and keep my money invested in the commodity currencies for now. But those that want to “trade” may want to take some of their profits in these currencies and wait for the possibility of cheaper prices in the coming months.

To recap, safe haven buying has pushed the dollar higher as sovereign debt worries continue in Europe. The BOE has entered the fray by agreeing to a swap agreement to support Irish banks, and bond traders have now turned their attention to Spain. Chuck gave us his opinion on a 60 Minutes story, and I shared a Barron’s article that does a great job of detailing the fall of the US dollar. And several trading desks feel that the commodity currencies are overvalued according to the PPP.

Chris Gaffney
for The Daily Reckoning