ECB rate decision looms...
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In This Issue..

* ECB rate decision looms...
* China pushes for a bigger seat at G20...
* Declining global reserves hurt US Treasuries...
* Commodity currencies come back...

And Now... Today's Pfennig!

ECB rate decision looms...

Good day... The dollar held on to its gains through out most of the day yesterday, as investors continued to look for a parking place in the volatile markets.  But late in the day, the sentiment changed and the dollar started getting sold vs. most of the currencies.  This dollar weakness continued overnight with the Euro gaining back 1 cent to trade back above 1.33 and the commodity based currencies of Norway, New Zealand, Australia, and South Africa all gaining over 1 percent vs. the greenback. 

What caused this sharp turn around?  I had to look hard to find anything which set this reversal in motion, and could only find references to the upcoming ECB rate decision due on Thursday.  The euro had come under selling pressure the past few days as currency traders bet the ECB would be cutting rates by 50 basis points on Thursday.  This cut would, of course, narrow the yield advantage the Euro holds over the US$ and therefore make it less attractive to investors.  There were also many who believed the ECB should follow the path of the US, UK, and Japan and begin using quantitative easing to further force down rates. 

But rhetoric out of the ECB late yesterday seemed to indicate the ECB would be reluctant to cut rates or follow up with untested 'quantitative easing'.  The ECB will stay focused on maintaining price stability in the Euro region, and not get pushed toward using new and untested efforts to flood the markets with liquidity.  The markets have now priced in a rate cut by the ECB later this week, and will be analyzing the accompanying statements to try and determine if additional rate cuts are planned.

Last week I touched on China's call to replace the US$ as the international reserve currency.  Indonesia, Malaysia, and Thailand quickly came out in support of China's call for a new global currency in order to insulate the world from a deep recession in the US.  Russia soon followed with a proposal of its own calling for a conference to draft new international agreements on global monetary and financial policies, including a new global accounting unit or a new global currency.  Even the new US Treasury Secretary said it sounded like a good idea, but quickly corrected himself to assure the markets the US$ is still the one and only reserve currency.  

Several Pfennig readers have written me asking more details about this new currency.  Is it the Amero?  Not hardly.  What China is suggesting is an expansion of the use of something called special drawing rights (SDRs), which were introduced by the International Monetary Fund back in 1969.  These drawing rights were issued to support the Bretton Woods fixed exchange rate regime which collapsed in the 1970s.  The value of these SDRs are based on a basket of four currencies, the US$, yen, Euro, and Sterling.  China has proposed expanding this basket to include the currencies of all major economies.  Countries would entrust a portion of their SDR reserves to the IMF.  The value of these SDRs would float with the broad basket of these currencies, and the SDRs would eventually replace existing reserve currencies.

Obviously, the introduction of this new global currency would be devastating for the value of the US$.  Countries, who are now obliged to invest a majority of their currency reserves into the US$ would no longer have to buy them.  And the US treasury market, where much of these reserves are parked, would also suffer.  As I said when the story first broke, I don't think this poses an immediate danger to the US$, as the proposal would require unprecedented cooperation among global trading partners; and the US is going rally support to fight it.  But it is something to keep an eye on, as it was met with a surprising amount of support.  

I don't think it is any coincidence that the timing of this proposal by China coincides with the upcoming G20 meeting.  China has been happy to grow their economy while mostly maintaining a lower profile at most of these economic summits.  It now looks like China will be demanding a more prominent seat at the table.  And justifiably so, as they recently overtook Germany to become the world's third largest economy.  They also hold more than a few US Treasuries, giving them even more power at the table.  The suggestion of replacing the US$ as a reserve currency was definitely a shot aimed at the big dog on the porch, and the US isn't in the best shape to defend itself right now.

While this proposal for a new 'global reserve currency' has received a lot of press not much has been written about the impact of the global economic slowdown on overall currency reserves and the resulting impact on the US treasury market.  China and Japan stockpiled huge reserves on the back of the US consumers, who eagerly bought goods produced in Asia.  But US consumers are cutting back, and global trade has slowed dramatically as a result.  Both Japan and China will therefore have smaller trade surpluses in 2009, and less money to invest back into the US treasury market. 

Unfortunately, this fall in global reserves coincides with a big increase in funding requirements by the US Treasury.  Funding requirements of all of the stimulus packages will dictate trillions of dollars worth of new supply.  The US government and Federal Reserve have now spent, lent or guaranteed $12.8 trillion in their attempt to get the US economy back on its feet.  Even the planned $300 billion of purchases by the Fed won't put much of a dent in that supply.  With less buyers chasing more supply, the price of these Treasuries will fall, and rates will rise.  Foreign investors will need to be enticed into purchasing this new debt, and the sweetener will be a fall of the value of the US$.

This decrease in overall reserves available for investment into the US treasury markets is probably a bigger threat to the US$ than the institution of a new global reserve currency.  While the new reserve currency is still a possibility, the reduction in global reserves, and the subsequent drop in US treasury purchases is a reality.

As I mentioned in the first paragraph, the commodity currencies were the big gainers overnight, with the Aussie and New Zealand dollars jumping over a cent vs. the US$.  The precious metals and oil all traded higher, providing additional support to these currencies.  With oil moving higher, the Norwegian Krone move up over 1% vs. the US$.

The markets are mainly concentrating on the ECB rate decision and talk of what will come out of the G20 meetings later this week.  Data released this morning in the US will confirm house prices in the US continue to drop.  The CaseShiller Home Price index is expected to show a drop of over 18%, but this number reflects January sales, and won't confirm or reject the better numbers released for February.  We will also get two separate measures of Consumer Confidence in the US, both of which are expected to show further deterioration of consumer attitudes.  Tomorrow will bring additional data on the housing and automobile industries in the US, neither of which are expected to show signs of a turnaround. 

I wanted to write a bit about the expected outcomes of G20, but my workout ran a bit over this morning, so I'll keep that for tomorrow.  Now on to the currency wrap-up:

Currencies today 3/31/2009: A$ .6908, kiwi .5701, C$ .7991, euro 1.3294, sterling 1.4282, Swiss .8765, rand 9.5533, krone 6.7387, SEK 8.2517, forint 232.54, zloty 3.5326, koruna 20.64, yen 98.30, sing 1.5206, HKD 7.7502, INR 50.825, China 6.8339, pesos 14.2218, BRL 2.331, dollar index 85.35, Oil $49.23, Silver $13.125, and Gold... 918.60

That's it for today... I have two of the four remaining teams in our office NCAA bracket, with UCONN and MICH STATE. I have to thank Mike Meyer for the picks, as I was in Florida when they drew teams.  The great thing is I am guaranteed to be in the finals, as these two teams play each other on Saturday.  Busy day on the desk yesterday, the metals calls continue to dominate our phones.  Looks like another rainy spring day here in St. Louis, I guess that is better than the snow we got this weekend!  Less than a week until opening day here in St. Louis!  Hope everyone has a terrific Tuesday!!!
Chris Gaffney, CFA
Vice President
EverBank World Markets

Posted 03-31-2009 9:46 AM by Chuck Butler