Print This Article

Fed Has Two Choices: Sink the Buck or Raise Rates

Chuck Butler (May 15, 2009)

Friday, May15, 2009

My Money Is On Sinking the Dollar

Also In Today’s Letter…

By Chris Gaffney Chuck handed me the reigns on the newsletter this morning, because I took an early flight home yesterday and got back to St. Louis much earlier than he did. The Las Vegas Money Show went well, as Chuck packed the presentation rooms with investors looking to learn more about investing in gold and currencies.

Attendance seemed like it was down a bit, but we stayed busy at the booth with investors looking for diversification. We also got to see a number of ‘old friends’ who stopped by the booth to say hi. All in all it was a good three days, but as always, it is good to get home and back into the routine.

The currency markets fell back into their established routine also, as fear drove investors out of riskier assets and back into the U.S. dollar. We saw a general reversal of the carry trade, with the Japanese yen the only major currency, which appreciated vs. the U.S. dollar.

As my colleagues pointed here in FX University out last week, investors have felt more confident about the global economy lately so they’ve dusted off their carry trades. (Remember: A carry trade is borrowing a low-yielding currency to fund an investment in a higher-yielding currency to earn money on the spread.)

But traders are still a bit skittish, and now they’re moving back out of these leveraged trades at the first sign of trouble in the global economy.

I’m Sure Trichet Knew About This Before He Started the QE…

Europe delivered the bad news overnight about the first quarter GDP for the 16- member euro region.

Gross domestic product fell 2.5% from the fourth quarter, including the 1.6% drop in this morning’s report. This is the biggest drop since euro-area GDP data was first compiled in 1995, and was 50 basis points higher than the 2% drop expected by most economists. Inflation data was also released for the euro-region this morning, and showed prices are holding steady.

This drop in GDP will likely put more pressure on ECB President Trichet and the ECB to step up ‘quantitative easing’ to stimulate the European economies. But I have to believe that the ECB got a hold of a ‘preliminary’ copy of this data long before it hit the news. In fact, I bet they knew the bad news was coming even before their meeting last week (hence the recent call for more quantitative easing).

Unemployment in the euro region continues to climb, and the flat inflation data will strengthen the argument for a more aggressive move by the central bank. While the ECB did leave themselves room to increase the money supply, they seem to be content to wait it out a bit before becoming too aggressive with monetary easing.

Enough Data Today To Shock Both Me and the Markets Big-Time

Since I have been away from the desk most of the week, the first thing I did this morning was turn on the screens to catch up on data being released today. It was a bit of a shock, as the list of reports filled the screen.

Inflation data was released first thing this morning, with the April CPI numbers here in the United States. Inflation was expected to show no change for the month of April, with only a small 1.8% increase in the core CPI compared to last year. However, CPI actually fell an astounding .07% – the biggest drop in 54 years! I’m sure Chuck will have more to say about that on Monday…so I’ll leave that to him.

The inflation numbers will be followed by the Empire manufacturing number, which everyone expected to show another major contraction in manufacturing here in the United States.

Our Get-Out-of-Debt Free Card Is About to Expire

Then we will get the all- important TIC flow data, which gives us an indication of the appetite of foreign investors for our U.S. treasuries.

Chuck and I have educated investors on the importance of TIC flow data for years. Here’s why: Foreign investment is the only thing allowing the U.S. to continue to live above our means.

With the large increase in the budget deficit predicted for 2009, foreign investment has become even more important. But several overseas investors, including Asian central banks, have started worrying about how much U.S. debt they’re holding.

But even if they wanted to continue financing our debt (and they have many self-serving reasons to do just that), the drop in global trade has put less money in the coffers of these export driven economies. They simply don’t have as much to invest as they did during the past few years.

Fed Has Two Choices: Raise Rates or Sacrifice the Dollar
My Money Is On Option 2

As of this morning, the TIC flow data is showing a major decrease (US$23.2 billion in March, versus an outflow of US$91.1 billion the previous month). That will put Bernanke and his boys in an even tougher spot.

There are two ways they can try to entice these foreign investors back into the U.S. treasury market. They can either let interest rates increase, or let the value of the U.S. dollar fall.

Now which do you think they will choose? They have been running the printing presses on overdrive in order to try and keep interest rates down to create another refinance boom. That tells me the Fed will try to do everything they can to keep interest rates down, so their only option is to let the U.S. dollar fall.

The drop in TIC flows, combined with a huge increase in funding requirements by the U.S., will have to lead to a general debasing of the U.S. dollar.

The Top Four Performers of the Year…

With the carry trade reversing, both the New Zealand and Australian dollar fell. In fact, they just posted their first weekly loss since February. Both these currencies have benefitted from a move back into riskier assets, and now the risk chasers are heading for the hills.

The kiwi also fell because New Zealand retail sales dropped in the first quarter almost twice as fast as economists predicted. But the main driver of the sell off in both the kiwi and Aussie dollar has been the reversal of investor sentiment, and the move back out of the carry trade positions.

The Australian dollar, which is coming off a pretty big drop last year vs. the greenback, is now predicted to be one of the best performers during the global recovery. As China’s economic engine revs up again, commodity prices will move back up supporting the Aussie dollar.

China’s infrastructure spending has already boosted the prices of base metals, which has helped to fuel a rally in the price of the Australian dollar. Mellon Capital Management Corp. released a report yesterday which stated the Aussie dollar would rally the fastest among the world’s major currencies. The report cites China’s US$585 billion economic stimulus plan to improve housing, highways, airports, and power grids.

The Aussie dollar has advanced 12% against the dollar since China announced the stimulus plan on November 9th. The Aussie dollar should continue to appreciate, so any sell-off due to carry trade reversals should be viewed as a great opportunity to add to positions.

Another commodity- based currency, which we have been watching is the Norwegian kroner. Right now, the kroner is the fourth best performing currency vs. the U.S. dollar in 2009. (The top is the Brazilian real, followed by the South African Rand and then the Australian dollar). Norway’s government announced it would raise spending and add to the stimulus package it announced earlier.

Dollar Looks Tired Compared to Com-Dolls

Norway will spend an extra 9.5 billion kroner (US$1.5 billion) to create jobs. The Norwegian mainland economy (ex oil, gas, and shipping) is predicted to contract 1.9% this year. But if we continue to see positive signs out of China, oil and shipping revenues should rebound, and Norway could very well post a positive GDP for 2009. I continue to feel the Norwegian kroner is one of the best investments for diversification out of the U.S. dollar.

And on that note… Let’s go to the Big Finish!

That’s it for today… I got home yesterday evening just in time to take my wife to the Billy Joel / Elton John concert. These are two of my favorite entertainers, and they put on a very good show. I am dragging a bit this morning as the concert didn’t get over until well past my usual bedtime. The weather sounds like it is going to be beautiful today, much nicer than the 100 plus temperatures in Las Vegas.

Hope everyone has a Fantastic Friday, and a Wonderful Weekend!!
Chris Gaffney, CFA

EDITOR’S NOTE: If the Fed and their buddies at the Treasury are desperate to debase (read: sink) your dollar, there’s never been a better time to diversify into stronger, better-managed currencies. Click here for a few ideas how.

Related Articles:

My Number #1 Pick for Currencies This Year

Commodity Currencies Overbought Since March

More From The Author