Waiting on the Fed

Good day… The dollar lost more ground yesterday as orders for durable goods fell more than forecast in May, casting more doubt on the strength of a projected rebound in business investment. The durable goods orders dropped 2.8% from their previous levels, almost three times more than expected. The less volatile ex-transportation number also showed a 1% drop. These numbers have to have the boys and girls at the Fed questioning their forecasts for gradual improvement in the economy the rest of this year.

Speaking of our friends at the Fed, the policy makers will be announcing their rate decision later today. With the disappointing data released lately, the FOMC will have to keep rates right where they are. While this rate decision is widely expected, the accompanying statement will be scrutinized as usual. Traders will look for any signals of a change in the Fed’s view of the future. While some are giving Bernanke credit for leaving rates right where they are, I think he just doesn’t have any other option. Inflation (as reported by the Fed) remains at the high end of the comfort zone keeping the Fed from lowering rates to help an economy which is slowly being drug toward recession by the housing slowdown. While some call the current state of the economy “Goldilocks” (not too hot, not too cold), I think it more resembles “Humpty Dumpty”. Everything looks just fine while on the way down, but the ground is quickly approaching.

Before we get the news from the FOMC meeting, we will see GDP, personal consumption, and the weekly jobs data. The GDP numbers are expected to show that the economy grew at an annual pace of 0.8% in the fist quarter, the weakest in four years as housing slumped. Personal consumption is expected to come in unchanged from the last estimate of 4.4%, which would indicate that there is growing inflation pressure here in the United States. And finally, the weekly jobs data will likely show a slight decrease in the number of applications for jobless benefits after the small jump last week.

So today’s data will be pretty dollar neutral up until the FOMC statement. I think the risk to the markets is that the Feds finally admit they are too rosy on their calls for the economy and the markets start leaning toward the rate cut camp. But as we have said in the past, inflationary pressures have really backed the Fed into a corner; so don’t expect any immediate indications of a rate cut.

There is little doubt about where rates are headed in Europe. Money supply growth in the euro region unexpectedly accelerated to close to the fastest pace in 24 years in May. M3 money supply, which the ECB uses as a gauge of future inflation (and which the U.S. FOMC chooses to ignore – don’t get me started), rose 10.7% from a year earlier. Additional data released showed that Germany’s unemployment rate fell to the lowest level in 12 years in June. The largest economy in Europe is looking like it will continue to fire on all cylinders.

This latest data all but assures that the ECB will continue to raise interest rates. Aggressive moves up by the ECB will narrow the interest rate differential with the United States. This narrowing will keep the euro (EUR) moving up versus the dollar. I have to believe we will see the euro test the $1.40 level before the year is over.

The pound sterling (GBP) has been enjoying a strong move back up also. Our good friend Jack Crooks at Black Swan Capital had this to say about the recent move:

“The British pound is dancing with the $2 per pound level like a Mexican jumping bean. It’s back over that mark today as housing prices in the region increased in June at their fastest pace in nearly two and a half years.

“That’s got traders salivating in anticipation of higher Bank of England interest rates. The central bank’s main man Mervyn King is due to speak later today. It’s expected he’ll give something nice and juicy to chew on ahead of the bank’s meeting next week to discuss monetary policy.”

Jack went on to talk about the Japanese yen (JPY), which has been pretty volatile as of late due to the carry trade:

“The yen strung together a couple of hugely positive sessions, but are we all done? Is that all the yen can muster? Hardly. Although a potentially slower than expected Japanese economy sure won’t help out efforts aimed at unwinding some of the carry trade.

“News out overnight showed a slowdown in Japanese industrial production for a third month in a row. The Bank of Japan has made it clear they’re closely watching the data before making any decisions on future interest rate increases.

“Even though Japan’s economy ain’t all that bad anymore, until consensus expectations change and the Bank of Japan gets down to business, traders will need some other catalyst to drive the yen higher.

“High-yielding currencies like the Australian dollar (AUD) and New Zealand dollar (NZD) moved sharply off their highs in light of carry trade reduction. But they’ve already turned it around and are locked in again on recent highs. Should these levels prove formidable resistance we could see renewed selling that would send these high-yielders back down, farther and faster than before.

Who knows, that might be enough to induce a fresh wave of yen buying.”

Unfortunately the recent data just doesn’t support another move up by the BOJ, so the carry trades will likely continue.

Jack mentioned that the high-yielding currencies of Aussie and New Zealand dollars have moved back up off of their recent pull back. In addition to buying due to the carry trade, the New Zealand dollar is benefiting from reports showing a pick-up in housing and a narrowing current account deficit. As readers will recall, Chuck pointed out New Zealand’s huge current account surplus at the beginning of last year and warned investors that this current account would need to come down. The narrower current account deficit suggests less money will be exchanged into foreign currencies. This is supportive of the kiwi, and all but assures that the central bank will fail in any renewed attempts to halt the currency’s rally. The New Zealand economy is growing at a very quick pace, and the currency will continue to reflect these strong fundamentals.

Currencies today: A$ .8463, kiwi .7690, C$ .9400, euro 1.3468, sterling 2.002, Swiss .8144, ISK 62.49, rand 7.1107, krone 5.9041, SEK 6.8616, forint 183.54, zloty 2.8073, koruna 21.26, yen 122.91, sing 1.5359, HKD 7.8161, INR 40.8385, China 7.6153, pesos 10.8095, dollar index 82.25, Silver $12.43, and Gold… $646.20

That’s it for today… Chuck went into surgery yesterday afternoon and everything was going fine as of our last update, the surgeons were expecting the operation to go well into the night. Kristin just came in and told me she heard that Chuck’s surgery went well and that he was up and speaking to his family. So they think they got all of it out, and now he begins the long recovery/rehab phase.

Looks like another rainy day here in St. Louis, sure wish we could ship some of this rain over to Lake Tahoe. The big boss, Frank Trotter is expected to be back in the office today, so better get to work! Hope everyone has a great Thursday.

Chuck Butler — June 28, 2007

The Daily Reckoning