What's Greece Going to Do?

Good day, and welcome to another fabulous Friday. I’m back with you again today as Chris and I pull the double-switch while Chuck takes some time off. I was on my back porch again last night reading through some stuff and thinking about what to write, so it felt like deja vu. The focus and headlines haven’t changed much from the beginning of the week, but there’s still plenty to talk about. The markets have landed on the idea of more stimulus from the Fed, so the Greek election has surprisingly taken a back seat as we have progressed through the week.

It’s definitely been a turn of events for the financial markets, as just last week everybody was bracing for Greece to leave the euro (EUR), which prompted the flight of liquidity into the dollar. As the drum for more action from the Fed has beat louder and louder, the allure has been fading away. Unless we see something catastrophic from Greece this weekend, it looks as though the Fed meeting next week will keep a captive audience. The moment of truth is finally upon us, so when Monday morning rolls around, it could be a much different story.

Nonetheless, the economic data here in the U.S. didn’t do anything to dismiss additional action from the Fed, but instead just gave them more opportunity to loosen the belt a couple notches. While the weekly jobless numbers usually behave as the opening act, this week they were thrown up on the main stage. These numbers can be volatile, but the trend has been moving in the wrong direction, so this was the last measure of employment before the Fed makes their decision on Wednesday. Since the labor market has become such an influential piece, the disappointing rise for initial jobless claims to 386,000 and the past few monthly jobs reports would certainly be the fall guy for those wanting more Fed action.

While the jobs figures may have fueled the fire, the inflation reports this week have given the scope to take action. According to these reports, we have no rise in inflation. Let me take that back, the reports say that inflation is actually falling. I saw a headline on Bloomberg that said the cost of living in the U.S. fell in May by the most in more than three years. Maybe I’m doing something wrong, but there’s no way that my basic cost of living has gone down, not to mention by the biggest margin in three years. I’ll bite on the whole it costs less to fill up the gas tank thing, but that’s as far as I go.

I know it’s much more complicated than this, but I’m not a complicated kind of guy. I’m a sucker for potato chips, so I’ve been buying a bag of chips every week to go with lunch for years now. Up until a year or two ago, I was paying about $3 a bag and could maybe find them on sale from time to time for $2.50, but now I have to spend just under $4 for the same thing. If I’m lucky, there will be a two for $6 deal, but that’s hit and miss. Even though this is small scale, these are the type of things that make me scratch my head when I see these inflation reports.

Anyway, the headline inflation figure fell by 0.3% in May and was the biggest monthly drop since December 2008, which was mostly due to a 4.3% drop in energy costs. Core inflation, which takes food and energy out of the picture, did rise 0.2% and the year-over-year figure remained at 2.3%. If things in Europe stabilize somewhat and the Fed does implement some type of stimulus, it’s certainly possible we could see the price of oil get back on the rally tracks. What’s the Fed going to do if employment remains stagnant and commodities, namely oil, rise as a result of newfound euphoria?

We also saw a revision to the first-quarter current account deficit widen to $137.3 billion from $118.7 billion, which is a three-year high. Again, revisions to many reports as of late haven’t been very friendly. We did see one of the various consumer confidence gauges increase a bit last week, but it still remains historically low. The drop in gas prices looked to be responsible once again, but you would think the shaky jobs situation would have more than offset that optimism. They don’t ask me, so who knows.

The reports due this morning should be interesting. We get to see one of Chuck’s favorite bits with industrial production and capacity utilization. Production is expected to fall from April but remain on the positive side with a 0.1% gain, and then the latter is forecast to remain on hold at 79.2%. We also get a regional manufacturing report, the Empire State Manufacturing Index, which is expected to disappoint as well, but these results can be all over the board. Other than that, the June U of Michigan confidence report is supposed to fall, and then we see the TIC flows for April. Remember when people actually looked at that report?

Next week looks to be a big one with the Fed meeting scheduled on Wednesday acting as the elephant in the room, so look for volatility and position squaring leading up to the decision. Other than that, it’s going to be dominated with the May housing numbers, as we get housing starts/permits along with existing home sales and the house price index. Just looking at the projections, it looks to be a mixed bag, with starts expected to rise and then both sales along with prices expected to fall short from the previous month. You would think with mortgage rates at basement levels that homes would be selling left and right, but I guess the fragile state of consumers and questions whether the market has actually bottomed keep things moored.

Moving into the currency market, the dollar got hit again yesterday. We didn’t see any haymakers, which I wouldn’t expect to see until the Fed makes a decision, but it did take a couple jabs. The table was already set by the time I got to work yesterday morning as all currencies, except for the rand (ZAR), were in positive territory. The leader, which Chris explained yesterday, was the New Zealand dollar (NZD) and didn’t look back for the rest of the day. When it was all said and done, every major currency was in the black, but silver just didn’t have the juice to keep up, and it finished with a loss.

The euro has defied the odds lately, but still remains on fragile ground. The currency traded in a very tight range in the European session and was around 1.2560 when I fired up the computer yesterday morning. After the U.S. data were released and had enough time to sink in, it didn’t take long to shoot up into the 1.26 handle by midmorning. In fact, it stayed above 1.26 for the rest of the day and finally settled in at 1.2630 as I was packing up for the ride home last night. Most of that move resulted from the inverse relationship with the dollar and it was able to shake off Moody’s credit rating downgrade of Spain to one level above junk.

As investors focused on the future growth prospects if the Fed does take action, risk assets got another shot in the arm. Even though it goes without saying, the higher-yielding currencies all topped the leader board and most of the majors had at least 0.50% returns. The peso (MXN) and Australian dollar (AUD) ended in a tie for second place, both finishing the day up 1% and reaping the benefits of lower risk aversion. All in all, I could probably copy and paste what I wrote Wednesday and it would still be relevant.

One of the more interesting stories came out of Brazil, which did end the day within earshot of a 1% gain. It seems as though the self-imposed curbs on foreign capital did too good of a job and the government is sitting with their tail between the legs. For the better part of the past two years, taxes and other measures have been taken to discourage the flow of hot money from abroad in an attempt to prevent the real (BRL) appreciating quickly. In other words, the higher interest rates in Brazil acted as a beacon for investors seeking yield in an otherwise barren landscape.

All of the jawboning and rate cuts has sent investors running for the hills and taking their money with them, so the currency has fallen like a rock so far this year. They got what they wanted, which was a weaker currency, but it’s all about the unintended consequences that come back to bite. Since the real dropped so quickly in such a short period of time that the government is now worried that inflation pressures from imports could have serious effects and limit the scope for future rate cuts. This is the kind of stuff we warn about when dealing with the real and similar currencies.

Anyway, the government announced yesterday they will exempt foreign loans with a duration of more than two years from the 6% tax but hasn’t commented if other measures will follow suit. The Brazilian economy has been suffering like many others and they have already cut interest rates to record lows, lowered domestic taxes and increased subsidies to businesses in an attempt to keep things moving along. This announcement later in the day overshadowed a disappointing retail sales report, but it will be interesting to see how investors react in the weeks ahead.

Moving on, we don’t talk too much about the Singapore dollar (SGD), since there usually isn’t much going on, but I thought a brief update would be in order. For those of you unfamiliar with this currency, the central bank uses the exchange rate, instead of interest rates, to control monetary policy, so they guide it against a basket of currencies within an undisclosed band and adjust the pace of appreciation or depreciation by changing the slope, width and center of the band. The central bank usually meets twice a year, in April and October, to set the policy for the upcoming period and they did decide in April to allow more currency gains to keep inflation under control.

Inflation is the primary focus when government officials make the evaluations, so a recent upward revision from 3.5% back in March to 4.2% would look to keep the appreciation bias on track. A June survey of economic expansion also showed a rise, while the government said momentum had picked up even though global risks remain elevated. The domestic employment picture has been so bright that restrictions had to be placed on foreign labor, as an influx of workers from overseas has flooded the market. The dynamic environment, solid fundamentals and a proxy for Asian growth have all given credence to the Singapore dollar as the best-performing currency so far this year, with over a 1.25% gain.

Since oil moved up about $1.75, both the Canadian dollar and the Norwegian krone were given the green light. While there haven’t been many foreign data reports to review, we did see the first-quarter capacity utilization rate in Canada tick higher. Canadian industrial companies ran at 80.7% of their production capacity and beat forecasts by turning in the highest figure since the end of 2007 as demand for vehicles and machinery increased. The price of gold got as high as $1,628 yesterday, so just another kicker for the commodity currencies.

Rounding out the currencies for today, the pound sterling (GBP) finished in positive territory by the skin of its teeth as the pro-foreign currency movement carried it along. It looks as though government officials are kicking around the idea of adding more stimulus into their economy to counter slowness and any fallout from the euro crisis. The plan calls for an injection of 5 billion pounds a month into the financial system along with a funding for lending program designed to encourage bank lending specifically to the nonfinancial sector.

As I came in this morning, things are right where I left them last night, but the weaker dollar bias has carried over so far, as the euro holds above 1.26 and the Australian dollar breaks on through to the other side of parity. Most currencies have remained in a tight range, but the Japanese yen (JPY) has jumped out to an early lead. The yen is getting some love this morning after the central bank left rates unchanged and refrained from expanding monetary stimulus. There was speculation leading up to the meeting that we would see some type of expansionary move, but the no action was a pleasant surprise.

Then There Was This: Major central banks are standing by to inject liquidity into the global economy to stabilize markets if the Greek election triggers financial shock, G-20 officials said. The central banks also have plans to ensure enough capital is flowing through the financial system if other key elections, including those in Egypt and France, trigger severe volatility, the officials said.

To recap: The Greek election took another ride in the back seat as speculation of further Fed action gathers steam. The increase in jobless claims and the decrease in CPI just fueled the fire, since jobs and inflation are at the top of the Fed’s list. The current account deficit widened to the biggest in three years, but that didn’t seem to bother anyone. Unless Greece drops the ball, the markets look to focus squarely on the Fed meeting next week. All of the major currencies finished in positive territory, but Brazil threw investors a bone by repealing a tax on foreign lending.

Mike Meyer
for The Daily Reckoning

The Daily Reckoning