Worst Housing Market Since the Depression

Good day… The data came in right where we expected concerning the U.S. housing market, and the dollar slid. Housing starts declined in May for the first time in four months. Building permits were up slightly, but this one piece of good news was more than offset with ABC consumer confidence, which was a negative 14 after last month’s negative 13. There will be no help for the dollar today as the MBA mortgage application index has already been reported to have dropped 3.4% after last weeks 6.6% increase.

The markets seem to be waking up to the fact that the housing market is nowhere near the bottom. Borrowers are being squeezed by the treasury markets’ recent sell off, which has increased 30-year mortgage rates the most since 2004. The National Median Home price is poised for its first annual decline since the Great Depression. An executive at the giant bond fund PIMCO said it best: “It’s a blood bath. We’re talking about a two to three year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock markets and corporate profit.” The U.S. housing market has provided the economy with support through the creation of wealth and the seemingly endless ATM of price increases. The recent increase in yields, along with the subprime mortgage meltdown is going to kick this support right out from under the economy, and the dollar is going to be drug down along with it.

The big winner overnight in the currency markets was the Swedish krona (SEK), which increased after the central bank raised interest rates and said that two more increases were likely. Increasing employment and slowing productivity growth threaten to fuel inflation according to the central bank. The move was expected, but the accompanying statement was a bit more aggressive than expected. “The price pressures we are seeing today make it necessary to increase rates,” said a central bank official. “We want them to proceed quickly, one in June and then in September and October.” The Swedish economic expansion last year set a six-year high, so the government feels it can get more aggressive with rate increases going forward. The Swedish krona can be purchased as a single currency CD and is also a part of our popular EuroTrax Index CD along with the euro (EUR), Swiss franc (CHF), and Norwegian krone (NOK).

The minutes of the last Bank of England meeting were released and show that BOE Governor King and three of his policy makers agreed with Chuck and I and wanted to raise interest rates this month. This very close vote is another indication that rates in England will increase as soon as July. King argued that a quarter point rate increase was needed because inflation risks are “on the upside.” Five of the Monetary Policy Committee’s nine members overruled him at the June meeting, partly because they didn’t want to surprise the financial markets. With King calling for a rate hike and inflation looking like it will again exceed the BOE’s 2% target, a surprise 50 bps move may be just what the British economy needs. The pound (GBP) rallied back above $1.99 and is clearly on a path, which will push it over $2.00 sometime in early July.

Ty Keough forwarded me a research report by Stephen Jen out of London that made a good argument for a further rise of the commodity-based currencies. The report read as follows: “We are revising up our forecasts for the commodity currencies (AUD, NZD and CAD). The biggest change in our view is that we now recognize, belatedly, how powerfully the emergence of China has affected the three commodity currencies, the CAD, AUD and NZD. Although these were previously known as ‘dollar-bloc’ currencies, we would consider calling them, from now on, ‘CNY-bloc’ currencies. Not only have the positive terms of trade shock and the positive export effects China [has] had on these economies been significant, but going forward, they are also likely to be the targets of M&A flows and private capital flows. These three currencies have been performing well since 2002, and I expect them to continue to reflect strength from China and the global economy. Among the three, however, I believe that the AUD should outperform.”

The Australian dollar saw some strength overnight as an Australian index of leading economic indicators rose in April, suggesting economic growth will accelerate as consumer spending and exports increase. The index’s annualized growth rate was 6.7%. The lowest jobless rate in almost 33 years and increased wages are prompting consumers to spend more, while sales of commodities to China are stoking export earnings. “The Australian economy is very likely to have entered a period of strong sustained economic growth,” said Bill Evans, chief economist at WestPac Bank in Sydney. The leading index is “now signaling that strong growth can be sustained through the first half of 2008.”

We agree with these views that the commodity currencies are set to continue to increase over the rest of 2007. The New Zealand dollar and South African rand (ZAR) have slightly more risk due to the large amount of investments that have flowed into them as a result of the carry trades. Australia and Canada seem to be the safest way for investors to take advantage of the continued commodity demand, which is a result of the tremendous growth of the Asian markets. While our Commodity Index CD has been the best performing index over the last five years, our newest WorldEnergy Index CD combines these two currencies along with the Norwegian krone and British pound. If the trends we have seen shaping up continue, this new WorldEnergy Index CD could be our #1 performer going forward.

Finally, the yen (JPY) is getting some love from the head of economics and strategy for the Bank of America in Tokyo. According to Tomoko Fujii of BOA, the yen will rise 4.5% against the dollar by year-end as a Bank of Japan interest rate increase will discourage investors from borrowing the currency to buy higher yielding assets. The currency is expected to appreciate after an August rate increase and reach 118 per dollar as the so-called carry trades fade. “The yen is likely to enter a moderate upward trend in late summer,” said Fujii. “The pace of BOJ’s rate increases will accelerate next year, making the yen carry trade lose its popularity.”

But according to the Deputy Governor of the BOJ, Toshiro Muto, the Bank of Japan remains committed to increasing interest rates gradually as the economy extends its expansion and prices rise. Not as aggressively as Fujii suggests. “The pace of needed interest rate adjustments will be determined based on improvements in the economy and price situation,” Muto said in a speech last night. “We don’t have any predetermined schedule.” Schedule or not, interest rates in Japan need to be increased, and the currency will need to rise in order to offset the tremendous global imbalances which have built up in the markets. The longer the Bank of Japan officials wait to increase rates, the larger the impact will be on the currency markets. The undervalued yen is a pressure cooker with the carry trade providing the fuel. As soon as the BOJ moves rates up, the whole thing could blow. And on that cheery note, I will move on to the currency scorecard:

Currencies today: A$ .8465, kiwi .7611, C$ .9378, euro 1.3429, sterling 1.9926, Swiss .8085, ISK 62.01, rand 7.0848, krone 6.000, SEK 6.9288, forint 185.21, zloty 2.8158, koruna 21.4165, yen 123.52, sing 1.5355, HKD 7.8148, INR 40.76, China 7.6180, pesos 10.7199, dollar index 82.51, Silver $13.33, and Gold… $661.10

That’s it for today… I wanted to wish my daughter, Lauren, a very happy 9th Birthday today. We celebrated at a local Japanese steak house last night, where Lauren was treated to quite a show by our chef. Kristin just called to tell me she is running by Starbucks, but I’m still trying to stay away from caffeine (though I’m awfully tempted with these long days!). No wired Wednesday for me, but I hope everyone has a great hump day!

Chuck Butler — June 20, 2007