Yield Differentials to Benefit Commodity-Based Currencies

As Mike wrote on Friday, the currency markets were pretty uneventful with the dollar continuing to drift lower and the commodity-based currencies moving higher. By the way, Mike did a fantastic job pfilling in the past two days didn’t he?!

The currency markets have been establishing a base pattern, with the dollar index trading right around 80 for about two months. Last week the DXY started drifting lower, breaking out of the sideways pattern and establishing a new move lower. The euro (EUR) chart shows a similar pattern, drawing a line just over 1.40 for a couple of months before starting to move higher last week. This is a very healthy pattern for the currencies, and shows that the underlying downward trend of the US$ remains. With this ‘base’ established, any pull back by the currencies will now have pretty firm resistance at these levels.

When I look at the longer-term charts of the dollar index, I see a similar pattern of ‘building a base’ during the last half of 2006. Once we moved off of this base, the dollar dropped quickly but then rebounded to test the level again. Not being able to move back up through this base, the dollar started a long decline, dropping over 17.5% in the next 18 months. So we could be seeing a nice set up for another big dollar move, especially if we test the 80 level in the dollar index and don’t see the dollar move through it.

In what reminded me of a Presidential campaign, Fed Chairman Ben Bernanke held a town hall style meeting in Kansas City over the weekend. The meeting will be broadcast in several parts on PBS this week, but excerpts were shown on Bloomberg this morning. This was somewhat of a campaign stop for Bernanke, as his first term will expire January 31, and he needs President Obama to reappoint him for another four years. During the interview Bernanke said the bailouts of the major financial institutions sickened him, but “I was not going to be the Federal Reserve chairman who presided over the second Great Depression.” During the open forum meeting he also warned against allowing the GAO to audit the Fed’s books. He believes this would call into question the Fed’s independence, and make it much harder for the FOMC to raise rates.

How is an ‘after the fact’ audit of the Feds books going to prevent the FOMC from raising rates? I think it would just make the members more accountable for their actions. Big Ben may just be setting up a smoke screen for the inflation that he knows is lurking around the corner. When the inflation raises its ugly head, Bernanke wants to make sure there are plenty of folks on whom to push the blame. He can start with his predecessor, Alan Greenspan, who is the real owner of this recession/depression. But I am getting off the subject, better get back to the currency markets.

This week looks like it will be a bit more eventful on the data front, with reports on New Home sales starting us off this morning. This report is expected to show a small up tick in the sales numbers for June, another sign that the housing market is at least slowing its descent. New home purchases hit a record low of 329,000 in January, and are predicted to come in at 352,000 for June. Falling prices and near record low mortgage rates have started to lure buyers back into the market, but with unemployment rising I question just how sharp of a rebound we will have. There are only so many ‘first time homebuyers’ out there, and unlike the go-go days of yore, individuals who are out of work are not going to be able to qualify for home loans.

Tomorrow we will get the CaseShiller Home price index along with consumer confidence numbers for July. Wednesday we will see durable goods orders along with the release of the Fed’s beige book. Thursday we get the weekly jobs numbers and Friday will end the week with a look at second quarter GDP, personal consumption, and the employment cost index. Friday’s GDP data will be closely watched, as it is expected to show that the US economy shrank at a 1.5% pace during the past quarter, much slower than the 5.5% drop in the first three months of 2009. Should be a good week of data, which could lead to a bit more volatility in the currency markets.

As Mike reported last week, the US stock market has been on a tear lately, with the S&P moving up over 100 points in the past month. Investors are moving back into US stocks as earnings reports come in above expectations. It is like someone has sounded the all-clear horn, but I think it is still a bit premature; especially for investors in the US. While the global economy does seem to be rebounding, much of the reported earnings here in US can be linked back to the government intervention. Sure the banks are making money, how couldn’t they with the US government helping them hide all of their bad debts, and pumping them full of cheap money. But how long can the US government continue to support the economy on their own? Consumers don’t look likely to open up their wallets anytime soon as they continue to pay down debt. And rising unemployment will keep the clamps on consumer confidence here in the US. Without a big pop in consumer demand, the US economy will struggle to recover, and the dollar will continue to move lower.

A report that I read last night by a Goldman Sachs economist echoed my feelings on the dollar. “Cyclically, we are not yet in a situation where the undervalued dollar could perform better,” Thomas Stolper, an economist in London wrote. “U.S. demand has to grow more strongly, which we do not expect anytime soon.” Goldman continues to call for the euro to rise to $1.45.

Another report shown on Bloomberg say’s the Norwegian krone (NOK) is a currency strategist’s favorite bet. A survey of investment analysts predicted the krone would be the best performing currency as it recovers from a ‘hugely’ undervalued position. The NOK has long been a favorite of our desk, but has struggled to keep up with the higher yielding commodity currencies of South Africa (ZAR), Brazil (BRL), Australia (AUD), and New Zealand (NZD). The krone should gain as Norway’s economic recovery prompts policy makers to start increasing rates for the first time since 2008 to control inflation. The OECD predicts the country’s GDP will shrink less than the euro region this year, and gain more in 2010.

Mike mentioned the return to a focus on interest rate differentials last week, and currencies of the commodity-based countries should be the first to begin raising rates. This was the environment that we were in during the big moves of 2003 and 2007. Commodity-based economies were booming, and raised interest rates to combat rising inflation. Investors moved in mass to the countries that were predicted to continue to raise rates, in order to take advantage of the yield differentials. 2009/2010 is looking like we could see this pattern of chasing high yield return, which would be a good thing for holders of the Australian dollar and Norwegian krone. Central banks in each of these two countries have indicated they will likely be the some of the first to start moving rates back up.

The euro should also receive a bit of a boost today due to improved confidence. German business confidence rose more than expected during July, suggesting Europe’s largest economy is shaking off its worst recession since World War II. The Bundesbank said last week that the economy shrank ‘only slightly’ in the second quarter after its record 3.8% contraction in the first three months of 2009.

Good news on the UK housing front seems to have established a floor for the pound sterling (GBP). UK house prices held their value for a third month in July after moving down over 7.7% over the past year. A stabilizing of the housing sector may encourage BOE Governor Mervyn King to consider raising rates. While interest rates are expected to remain low through the end of 2009, some economists are now predicting that King will begin moving rates higher early next year. Inflation expectations in the UK are the highest of any in the Group of Seven industrialized nations, as the BOE was the leader on using ‘quantitative easing’ to support their economy. But these unorthodox moves by the BOE are widely expected to trigger a sharp rise in inflation as the UK economy begins to recover. The BOE will need to raise interest rates to offset rising inflation, and will likely be the first of the G7 to start raising rates. As I mentioned above, expectations of a rate rise may push the pound higher.

The Daily Reckoning