Volatility Drains Liquidity from the Markets

Good day… It’s great to be back in St. Louis and on the desk again. Sorry for the long delay in getting the Pfennig to everyone on Friday, we had some problems with the servers and only ended up getting the Pfennig out after some hard work by our tech guys. Hopefully you will be receiving this morning’s in a more timely fashion.

The San Francisco Money Show was a great experience, and the timing couldn’t be better for our products. The market volatility we saw last week played right into my presentations on how to protect your assets from just this type of market movements. Both presentations were full of people eager to here about our alternative investment options, and the questions lasted well past the time they gave me to present. But enough about the SF Money Show, the currency markets have started to move back up, so let’s go.

With everything except the Japanese yen (JPY) and Swiss franc (CHF) getting sold Friday, it was nice to come in this morning and see most of the currencies moving back up versus the U.S. dollar. The euro (EUR) is back above 1.3650 and the pound (GBP) above 2.02. The kiwi (NZD) and Aussie (AUD) are both still weak, but seem to have leveled off at around the 0.7550 and 0.85 levels respectively. The big winners in all of this market volatility have been the Japanese yen and Swiss franc, both of which are benefiting from the reversal of carry trades. With volatility moving back up, I would expect to see more of this unwinding, and additional strength from these two funding currencies.

The pound sterling rose against the dollar on speculation that the Bank of England will step in and raise rates this Thursday. We had some mixed data out of the United Kingdom today regarding their housing markets, as U.K. house prices increased at the slowest pace since January 2006. But another report showed that U.K. banks approved more mortgages than forecast in June. Since the mortgage approval rate is a forward looking number, the markets fear that the housing market in the U.K. will remain overly hot; and the BOE will have to raise rates again to keep inflation in line. BOE Governor King had to write a public letter explaining why inflation was above the 3% limit last March, and he certainly doesn’t want to have to write another one so soon. Look for the BOE to raise interest rates by 0.25% on Thursday, which will keep the pound well bid.

As I mentioned above, both the kiwi and the Aussie dollar remain weak due to selling linked to carry trades. We have been warning investors of this possibility, and as expected, the kiwi took the harder fall selling off 6.1% since last week with the Aussie dollar down 4.3% in the same time period. The other high yielding currencies have also sold off as the trades are being reversed, and profits are being used to pay back the carry trade loans.

The Australian dollar should be somewhat sheltered from the fall-out, as data will likely show that home building approvals increased in June, as rising employment and a decline in rental vacancies encouraged investment in property. Australia’s lowest jobless rate in 33 years and near-record consumer confidence are both boosting an economy that expanded at the fastest pace in more than three years in the first quarter. Interest rates will continue to be moved up, giving additional support to the Aussie dollar. I would look at the recent weakness in Aussie dollar as a great buying opportunity.

Did you see our own Chuck Butler quoted in Agora Financial’s 5 Minute Forecast over the weekend? They picked up on some of the thoughts he sent me on Friday morning. Chuck sent me the following thoughts last night:

“OK… Here are some random thoughts on a Sunday night after my beloved Cardinals came back from at least 5 runs down to win for the second day in a row.

“I’m very concerned about a trade bill aimed at China that was passed by the Senate Finance Committee on Friday. Now there are no guarantees that this will ever come to a law… But the fact is that there are many more of these where this one came from, AND it comes at a time when credit in the U.S. is drying up like a marathon runner in Las Vegas. Oh… Why is this a problem you ask? Because… Who has been providing credit to the U.S. by the boatload? Ahem… It’s China… Uh-Oh!

“U.S. GDP rebounded at a stronger-than-expected 3.4% annual rate in the second quarter, stronger than market estimates of a 3.2% pace. However, the first quarter’s anemic growth was downwardly revised to a 0.6% pace in the first quarter, which actually makes the second quarter rebound look even better. But remember this my friends… A STAR SHINES THE BRIGHTEST BEFORE IT BURNS OUT!

“With the mortgage meltdown just now beginning to show its gnarly teeth, the third quarter ought to be interesting…

“Risk aversion remains the flavor of the month in the markets (I prefer chocolate) and that is responsible for investors rushing for the ‘flight to safety door’… And that has the dollar back on the draft board. But I’m not buying the fact that the dollar has reached terra firma. This is just a short-term rebound for the dollar (except versus yen and Swiss francs).

“Recall about 10 days ago, I borrowed a line from my old friend (NOT!) Big Al Greenspan, and said that in my humble opinion the stock market performance was ‘irrational exuberance’… It certainly looks as though that’s coming to fruition… But, I’m not a stock analyst, I don’t play one on TV, and I didn’t stay at a Holiday Inn Express last night… It was simply an observation on my part.

“The important thing to remember here is that investors who hold nothing but U.S. denominated investments, like stocks, need to look to diversify out of the dollar.”

I certainly agree with Chuck, and diversification is the key in volatile times like now. This was the message I delivered in San Francisco, and what we have preached for the last several years.

The Japanese yen rose again over the weekend as Prime Minister Shinzo Abe’s party lost its majority in upper house elections. Abe could have stepped down, but instead decided to retain his post which is supportive for the yen as it lessens the political instability. His party still controls two-thirds of the more powerful lower house where governments are formed, so Abe is likely to survive any opposition pressure for him to step down. But Abe will likely have to avoid raising sales taxes and close the income gap to appease opposition parties, supporting consumer spending and the currency. Abe originally planned to start debate on tax reform, including raising the sales tax, after upper house elections, but the defeat means any increase in taxes is now dead.

The BOJ won’t have to give much consideration to politics and can focus on the economy, which is doing well. I would expect to see an increase in Japanese interest rates after the BOJ’s meeting Aug 22-23. Japan’s industrial production increased in June, ending the worst manufacturing slump in almost two years. The IMF last week raised its forecast for world growth, and Japan will continue to take advantage of this global strength. Rates will have to continue to move up in Japan, and the yen will continue to rise.

China ordered banks to set aside larger reserves for the sixth time this year to curb lending and investment after the economy grew at the fastest pace since 1994. By increasing reserve requirements, China is pulling out some of the liquidity in the markets and controlling inflation. Can anyone guess another excellent way to slow the economy? Let the renminbi (CNY) move up in value! China has begun to accelerate the renminbi’s appreciation versus the U.S. dollar, and I would look for them to continue.

Hank Paulson is taking credit for “talking” the Chinese into increasing the renminbi, but the markets are driving this change, not the U.S. Treasury Secretary. As Chuck wrote this morning, Congress continues to push bills that would restrict trade with China as a retaliatory move against the weak renminbi. Any moves in the currency, either forced by the markets or due to pressure from Mr. Paulson, will help us avoid these trade sanctions. A strengthening renminbi is good for the global economy, no matter the reason for the move.

Currencies today: A$ .8487, kiwi .7581, C$ .9363, euro 1.3668, sterling 2.0243, Swiss .8318, ISK 62.11, rand 7.1862, krone 5.8593, SEK 6.7328, forint 185.05, zloty 2.7874, koruna 20.4764, yen 118.22, sing 1.5146, HKD 7.8249, INR 40.55, China 7.567, pesos 11.013, dollar index 80.84, Silver $12.7199, and Gold… $661.87

That’s it for today… It’s great to be back home. I understand what Mark Twain was saying when he said, “The coldest winter I ever spent was a summer in San Francisco” as temperatures were downright chilly on my morning runs along the pier. Back to work today, and we are short handed on the desk again so it will be a busy Monday! Hope everyone has a great start to their week!!

Chuck Butler — July 30, 2007

The Daily Reckoning