Waiting on the central banks…

Good day…The currency markets held their ground in European and Asian trading over the past two days with the commodity currencies staying near their record highs. Traders this morning are awaiting rate decisions by the Bank of England and the European Central bank. With trade desks still understaffed, the markets will likely be somewhat thin making them susceptible to wild swings should we get an unexpected move from one of the central banks.

Either one of the central banks reporting this morning could surprise the markets. The BOE is expected to move rates up .25%. But as we have reported over the past few weeks, BOE Governor Mervyn King has been pressing the other board members for a rate increase and was just barely defeated in June. Inflation has continued to remain well above the BOE’s target, and the bank predicts economic growth will reach 3 percent this year, the fastest pace since 2004. This would be an excellent opportunity for King to convince the BOE to move 50 bps in order to shock the economy and slow inflation. But no matter if it is a quarter point or half point raise today, the Pound Sterling will continue to strengthen as interest rates in the UK are the highest among the Group of Seven industrialized nations.

The European Central Bank will also announce its rate decision this morning. While the BOE is expected to raise .25%, the ECB is widely expected to leave rates unchanged but point to more interest rate increases in the near future. The ECB has increased rates eight times since late 2005 as the fastest economic expansion in six years gave companies room to raise prices and encouraged workers to demand more pay. While last month’s increase took the key rate to a six-year high, the ECB said it’s still low enough to fuel growth. Government and industry reports in the past two weeks have supported the case for higher rates. Growth in manufacturing and service industries accelerated in June and unemployment fell to 7 percent in May, the lowest since records began in 1993. M3 money supply growth, which the ECB uses to gauge future inflation, unexpectedly accelerated to 10.7 percent in May, close to the fastest pace in 24 years. With all of the economists predicting no change in rates, the risks are that the ECB goes ahead and moves rates up now which would send the euro up another couple of cents. Either way, the euro will remain well bid, and continue its climb toward 1.40.

After these rate announcements, we will get the weekly jobs report and ISM non-manufacturing data released here in the US. This report on service sector job growth follows a report on Tuesday which showed manufacturing jobs grew in June at the fastest pace in 14 months. The service sector employment report is expected to show a slight dip but will stay near what is considered a healthy level. The weekly jobs report will likely show a small gain in jobs today, as will tomorrow’s Labor report for June. All of this data points toward a very resilient labor market in the US. But I don’t expect any of this positive news to be reflected in the US$. The currency markets are trading on interest rate differentials, and none of this data is strong enough to suggest a move up in rates by our Fed. With US rates stagnant and rates overseas heading up, the dollar will continue to slide.

Interest rate expectations have helped push the Canadian dollar to within a cent of its 30 year high vs. the US$. The loonie, as the Canadian currency is called, has climbed 10.2 percent this year as oil prices have supported the economy. Commodities including oil make up about half of Canada’s exports. With strong demand out of Asia, the commodity markets continue to support the Canadian economy and keep the currency in demand. The Canadian central bank said on May 29th that it would have to lift rates “in the near term” to stem inflation. The central bank meets next on July 10 at which time policy makers are expected to raise rates a quarter point. And the currency markets don’t think this will be the last move, as they are pricing in several more rate hikes from the Bank of Canada. More good news for our WorldEnergy and Commodity Index CD holders.

Iceland’s central bank kept its benchmark interest rate unchanged at a record high for the fourth meeting in a row as the inflation rate remains above the bank’s target. Some had expected the central bank to start cutting rates as the economy contracted for the first time in three years in the first quarter. But the central bank is still worried about a return of the runaway inflation we saw last year, along with a very high current account deficit. The bank wants to avoid cutting rates too early to prevent a surge in domestic demand that would widen the current account deficit and undermine the krona. The current account gap narrowed to 9.4 percent of GDP in the first quarter, from 26.5 percent on the whole of last year. Inflation slowed to 4 percent in June from 4.7 percent the month before. We would expect the bank to start lowering interest rates toward the end of this year, but until then investors will continue to enjoy the highest interest rates in the industrialized world.

News out of Japan will keep the yen from gaining any more vs. the US$ today. Japan’s broadest indicator of the outlook for the economy signaled for a seventh moth that the longest expansion in more than 60 years may slow. The leading index was reported at 30 in May, lower than the 40 reading which was expected and below 50 which indicates the economy may cool in three to six months. This index contradicts the Tankan survey which showed sentiment among large manufacturers near a two year high and service sector confidence at a 15 year high. Other reports for May showed the economy will probably keep expanding. Export growth almost doubled, the jobless rate held at a nine-year low of 3.8 percent and household spending climbed for a fifth month, extending the longest run of gains in three years. Retail sales rose for the first time in eight months. So we have an abundance of data which contradict this leading index. I still think the BOJ will start raising rates next month.

The Mexican Peso has risen this week after Standard & Poor’s raised the country’s credit rating outlook. The peso traded near a two week high as S&P lifted the outlook to positive from stable. President Felipe Calderon’s success in getting a bill passed in March to cut government spending on pensions and a proposed increase in taxes were reasons for the upgrade. But before you go rushing to invest into the peso, S&P still rates Mexican foreign debt BBB, the second lowest investment grade. There is still lots of risk here, and with interest rates substantially below those of Iceland, I’m not sure you are being paid enough for these risks.

I want to close out today’s Pfennig with a big thank you to the city of Boston and the Boston Pops. It ends up one of the musicians is a Pfennig reader, and sent me a note last Tuesday. We took his advice and walked down to the Charles River on July 3rd to hear the ‘dress rehearsal’ for last nights celebration. The weather on Tuesday night was amazing and we enjoyed listening to the music while looking out over the river. Last night the weather was not nearly as good, as it rained off and on. But the fireworks, choreographed to the music, were truly awesome!! I would encourage everyone to put ‘watching the fireworks on the banks of the Charles river while listening to the Boston Pops’ on their list of things to do. It is an amazing event.

Sometimes Chuck and I get messages from readers accusing us of being US bashers or un-patriotic. I know I speak for both of us when I tell you that we are both very proud to be Americans. We both love our country very much, and wouldn’t want to live anywhere else. We don’t always agree with the way our leaders are running things, but that is what makes the US so great; we have the freedom to disagree. While we urge investors to diversify their holdings outside the US$, please don’t confuse this with a dislike of our country. Now on to the currency roundup:

Currencies today: A$ .8597, kiwi .7871, C$ .9452, euro 1.3643, sterling 2.0192, Swiss .8243, ISK 61.40, rand 7.0105, krone 5.8086, SEK 6.7128, forint 180.49, zloty 2.7599, koruna 21.007, yen 122.54, sing 1.5196, HKD 7.8158, INR 40.38, China 7.5980, pesos 10.778, (no dollar index quote), Silver $12.70, and Gold… $657.40

That’s it for today…Congratulations to Jennifer and John on the birth of their first child, Andrew Walsh Monday night. I am told by Frank Trotter that both are doing well. I head back to St. Louis today, we had a great time in Boston, but I am looking forward to not having to write the Pfennig in a darkened hotel room! Hope everyone has a great Thursday.

Chuck Butler — July 05, 2007

The Daily Reckoning