Waiting On The Numbers

Good day. As expected, we had a very flat trading day in the currency markets yesterday as traders watched for any signs of easing in the Middle East tensions. Without any breakthroughs in Lebanon and no data to push the markets, we saw the dollar just drift throughout the day holding onto the gains it made in Europe.

This morning we see the dollar trending off before the release of the consumer confidence and existing home sales reports later this morning. These reports should highlight slower growth in the United States, confirming Chairman Bernanke’s hint at a pause. Consumer confidence will slide to a five-month low in July, as the high price of oil, Middle-East tensions, and 17 straight increases in borrowing costs weighed on consumers.

The 17 consecutive increases by the Fed have also started to trickle through to mortgage payments, hitting consumers’ disposable income. Purchases of previously owned homes are predicted to slide in June to an annual 6.6 million pace, the fewest in five months.  That would cap the slowest quarter for sales in more than two years. The housing market, which has been one of the major supports for the U.S. economy, is definitely starting to show some signs of a slowdown.

If today’s reports come in as weak as expected, we should see some selling of the dollar.  The technical charts also support this expected sell off. As I have said before, most of us here on the trading desk are not chartists, but study the fundamentals of the economies.  Even though we aren’t technical traders, we still listen to the chartists. Right now, most of them are predicting a decline in the dollar this week, as the dollar index has fallen below a key level on charts.

The New York Board of Trade’s dollar index has fallen below 86.51, which represents 50 percent of the move from an almost decade low of 80.39 on Dec 31, 2004, to a two-year high of 92.63, reached on Nov. 16, 2005. Fifty percent is significant, according to a number sequence used by traders called Fibonacci. Other Fibonacci points are 38.2 percent, 50 and 76.4 percent. A break of one indicates a currency may move to the next.  For the dollar index, that would be 85.06, a 61.8 percent retracement from the high.  Again, please don’t e-mail me with questions on technical trading, as I am not a chartist.  But I do believe these numbers are significant. They show what our fundamental analysis has been telling us: expect a weaker dollar in the next few weeks.

Now, on to something I mentioned yesterday that caused a flurry of e-mails in the Pfennig reply box. I stated that the Canadian dollar had fallen out of favor with currency traders. Our fearless leader Chuck Butler is in Canada right now, so I e-mailed him to ask him to share some thoughts on the current level of the loonie. So, here is a report from our “man on the ground” in Canada:

“I’ve been reading a lot of research lately on the Canadian dollar/loonie that suggests the currency has gone about as far as it can go. They base this on the fact that it has experienced a huge run the past three years, and that the Bank of Canada seems to be content in letting interest rates remain at current levels…

“Therefore, I’m putting an amber light on the loonie. I think if too many traders are calling for a lower loonie; I don’t want to be standing in front of that bus.

“Now, I know that a lot of you will start calling me names, because I’ve been such a bull for the loonie, based on commodities, but things have changed. And as Lord Keynes once wrote, ‘When the facts change, I change my mind. What do you do, sir?’

“Now this isn’t saying the bottom is going to fall out on the loonie. In fact, if you scour around you will find people that still believe in the loonie (like I want to believe in the loonie). For instance, ‘I still believe that the Canadian economy will outperform many countries and that makes a good case” for the currency, said Firas Askari, head currency trader in Toronto at BMO Capital Markets, the securities unit of Canada’s fourth-largest bank. BMO forecasts Canada’s dollar will gain to 90.5 cents in three months.

“Last week, Dennis Gartman, an economist and the editor of The Gartman Letter, recommended buying Canada’s currency against the U.S. dollar, citing the country’s natural resources. ‘The clear trend is toward a stronger Canadian dollar,’ he wrote.

“So, don’t go breaking your loonie CD. Just make certain that you call us before the next maturity to discuss your options. If you remain a loonie bull, then roll it. I just want to make you are aware of what traders are saying.”

Thanks to Chuck for sharing his wisdom on the current situation in Canada.

China’s National Bureau of Statistics gave the dollar bulls something to worry about as it said the country should diversify its foreign-exchange reserves. China buys dollar-denominated assets such as U.S. debt with its reserves, which have risen an average of $20 billion each month this year to become the biggest in the world. The purchases have helped buoy the U.S. dollar, which needs to attract $2.5 billion a day in foreign capital to fund the current account deficit.

We have been warning investors about this huge deficit and our reliance on foreign central banks for the past few years. While SIRT (Stupid Interest Rate Talk) dominated the currency markets over the past two years, the current account deficit has not gone away, and our reliance on foreign countries has only increased. With the interest rate story finally dying down, news of foreign-exchange-reserve diversification should have a more dramatic impact on the currency markets.

U.S. dollars make up somewhere between 70 and 80 percent of China’s $941 billion of reserves, so a diversification will definitely cause a sell-off in the greenback. The statement from China said it best: “The U.S. dollar may continue to weaken, increasing the risks of foreign-exchange losses in our currency reserves.” Any time you have the country with the world’s largest reserves questioning their dollar holdings, it is significantly negative for the dollar.

The currencies that stand to benefit from this diversification? While all non-U.S. currencies could rally, I believe you will see the biggest gains going to the most liquid offsets to the dollar, the Euro and the Japanese yen. These would be two currencies that China would want to hold, as they are two of their largest trading partners after the United States.

Currencies today: A$ .7559, kiwi .6267, C$ .8782, euro 1.2646, sterling 1.8508, Swiss .8034, ISK 73.21, rand 6.96, krone 6.28, SEK 7.32, forint 214.95, zloty 3.08, koruna 22.41, yen 116.66, baht 38.03, sing 1.584, INR 46.83, China 7.9872, pesos 10.89, dollar index 86.22, silver $10.99, and gold $621.

That’s it for today. Thanks again to Chuck for his words of wisdom from the great white North. Remember, we don’t expect a massive sell off in the Canadian dollar, but question whether it has the potential upside that other currencies now have. We still like the long-term fundamentals of Canada, but look for the currency to just hold here for a while.  Hope everyone has a great Tuesday!

Chris Gaffney
July 25, 2006