Currency Markets Take a Rollercoaster Ride

"The report by the Fed's district banks showed a 'slow pace in manufacturing in most areas, while the housing market continued to restrain the expansion'. Expansion?!? In their dreams!"

by Chris Gaffney

In This Issue…

Rollercoaster ride for the US$
M3 growth fuels the US stock market
New Zealand and Poland raises rates
Norway surprises with no change

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And now…today's Pfennig!

Currency Markets Take a Rollercoaster Ride

Good day… The dollar rallied for a short period yesterday after reports showed that durable goods orders rose more than forecast last month, and sales of new homes increased. But the rally didn't last long as traders shifted their focus to tomorrow's GDP numbers, which will likely show that the slowdown in the U.S. economy continued in the first quarter.

This morning, Europe decided yesterday's U.S. data, combined with an expected decrease in today's weekly U.S. unemployment figures, were good enough for the Fed to go ahead and move rates up, so the dollar has rallied back. The yen (JPY) has been the big mover overnight as it moved back above 119, more on that latter.

Yesterday morning started out positive for the dollar, as durable goods orders rose more than forecast during March. The 3.4% rise in orders was mainly due to an increase in orders for aircraft from Boeing (NYSE:BA). New home sales advanced 2.6% following a 4.2% drop in February, but this increase was actually less than expected and last months figures were revised down. With the currency markets pushing the dollar down, these positive numbers weren't strong enough to keep the dollar strong and the greenback quickly reversed its initial rally to close last night very near its all time low versus the euro (EUR).

Currency traders are now focusing on today's weekly unemployment data, which will probably show a decrease in the number of initial jobless claims, and tomorrow's GDP numbers, which will likely show a continuation of the slowdown we saw begin in the last quarter of 2006.

It looks like the European currency traders feel the FOMC has enough ammunition to go ahead and push rates up again - but I don't think so. As I said yesterday, the U.S. economy and the economies of Europe and Asia are moving in opposite directions. While the central banks of Europe and Asia continue to push rates up to combat inflation in their growing economies, the FOMC is having to just 'hold the line' with interest rates as the U.S. economy isn't able to withstand another interest rate increase.

The Beige Book, which was released yesterday afternoon, confirmed "only modest or moderate" economic growth in the U.S. economy. The report by the Fed's district banks showed a "slow pace in manufacturing in most areas, while the housing market continued to restrain the expansion". Expansion?!? In their dreams! The U.S. economy is hardly expanding, and is more likely contracting as growth slows, confidence falls, inflation rises, and unemployment is stagnant. No, I would hardly label the U.S. economy as expanding.

So if the U.S. economy is slowing down so much, why is the stock market hitting record highs? The answer to that question can be found in the M3 numbers. You may or may not remember M3, which the Fed conveniently quit publishing back in March of 2006. M3 is the broadest measure of money supply and is used by the European Central Bank and several other central banks as one of their key measures of inflation.

Well the Fed may have quit publishing the M3 data, but they continue to publish all the data that goes into the calculation - and our friends over at Shadow Government Statistics have a chart which demonstrates just why the Fed decided to keep M3 under wraps.

A look at the chart shows that the Fed is pumping up broad money supply at an astounding rate of 11.8% per year! All of this rapid money supply growth is reflected in an increase in equity prices. The stock market needs to rise just to keep pace with all of this newly created money. As long as the Fed doesn't rock the boat with another rate hike or by turning off the spigot of money flowing into the markets, the equity markets will continue to run.

But all of this money supply growth has a negative impact on the dollar. Inflation is a currency killer, and looking at the broadest measure (M3), money supply growth is out of control; and U.S. inflation is also running out of control, whether the government wants to admit it or not. The dollar has been able to keep up so far due to foreign investment flows, but once they start to see better opportunities outside the United States, the house of cards that the Fed has built will come tumbling down.

But enough about the United States, many of you read this for news on the currency markets so let's look at what happened over the last 24 hours. We had three different central bank decisions with New Zealand and Poland raising rates, while Norway surprised the markets by holding rates steady.

New Zealand raised its rates to 7.75%, which is the second highest after Iceland among AAA rated nations. Reserve Bank Governor Alan Bollard tried to keep the currency markets from strengthening the kiwi (NZD) too much by omitting a reference to more increases. Bollard also said the currency was priced above its fundamental value as it trades near its 22-year high. Bollard faces the dilemma of trying to cool domestic demand while limiting the damage to exporter's earnings. The reserve bank now seems to be on hold, but the high rates continue to attract Japanese and other investors.

The Norwegian krone (NOK) fell the most in three weeks after the central bank unexpectedly kept its benchmark rate unchanged, as inflation remains below its target. The krone fell to the lowest since April 9th because of the surprise move, but recovered as investors took the opportunity to take on positions in the krone.

The economy of the world's fifth largest oil exporter has grown in excess of 4% for three years, bringing the unemployment rate to the lowest since 1989. Yet, the bank's preferred measure of inflation was 1.5% in March (below the 2.5% target) as cheap imports from Asia and increased domestic competition curtailed prices. I believe they should have moved rates up, but we will have to wait and see if the bank's move was the correct one.

But the best performing currency year-to-date has been the Icelandic krona (ISK), which is up over 10.5% versus the dollar in 2007. Iceland's inflation rate fell to 5.3% in April, a 13-month low. Even though inflation is falling, it remains above the bank's 2.5% target, leading the central bank to forecast that it wouldn't cut rates until at least November.

The fundamentals of this economy remain strong with 13.9% GDP growth year-on-year, a federal budget surplus of 3.2% of GDP, and a jobless rate of just 2%. The negatives for this economy and currency remain the disturbingly large currency account deficit (16.5% of GDP) and its exposure to the carry trade. As investors have seen, this currency can be extremely volatile and should be considered only for the speculative portion of your investment portfolio.

Speaking of the carry trade, the favorite funding currency took a dramatic fall again overnight, as currency traders discounted the possibility of a rate increase tomorrow by the BOJ. The yen moved back above 119 as investors moved back into higher yielding currencies and out of the yen. Don't expect any major moves up by the Japanese yen until the BOJ is forced into raising rates.

Japan's trade surplus widened to a record in March, buoyed by a weaker yen and exports to China, which replaced the United States as the nation's largest trading partner. As long as China keep the renminbi (CNY) down, Japan will do everything they can to keep their currency down also, in order to maintain their trading relationship. Both currencies are extremely undervalued, but neither is willing to make the first move up.

Currencies today: A$.8297, kiwi .7398, C$ .8923, euro 1.3603, sterling 1.9935, Swiss .8278, ISK 64.35, rand 6.9915, krone 5.9751, SEK 6.7322, forint 180.77, zloty 2.7733, koruna 20.67, yen 119.36, baht 32.60, sing 1.5150, HKD 7.8217, INR 40.87, China 7.728, pesos 10.933, dollar index 81.70, Silver $13.63, and Gold $680.82

That's it for today… Our Cardinals are playing a day game today at Busch Stadium, but they are calling for more thunderstorms so it will be touch and go to see if they get it in. Currency markets look like they want to take the dollar up this morning, so if you have been waiting for a bargain now is your chance! Hope everyone has a great Thursday.

Editor's Note: Chris Gaffney is Vice President of EverBank World Markets and the alternate author of the popular "Daily Pfennig" newsletter. This valuable newsletter is delivered via email to tens of thousands of market watchers globally, and helps traders stay on top of the economic, currency, and market happenings.

Mr. Gaffney has been involved in investment services since 1987 and is director of sales for structured products at EverBank World Markets. He is a Chartered Financial Analyst and also holds degrees in accounting and finance from Washington University in St. Louis.

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