US markets absorbed more negative data on Friday and the DOW JONES recorded a second consecutive week of losses as European markets trembled but looked for a brighter future. European shares slid for the second straight day but investors continued to take money for US markets and invest in European markets. Flows into European equities from US funds reached a two-month high in the week ending August 14, 2013. Trading has been light for most of August.

Federal Reserve policy is dictating market stability and speculation that tapering will commence next month weighs heavily on investors. Markets anxiously await the Federal Reserve policy meeting on September 17-18. US equities still show significant gains for the year but European markets are mounting a rally while th FTSEurofirst 300 and Euro STOXX 50 have gained about 8 percent year-to-date and posted gains for the second consecutive day.

By noon, the DOW was down 32.33 points, off 0.21 percent to 15,079.86. The S&P 500 Index was off 5.61 points or 0.34 percent at 1,655.71. The Nasdaq showed a gain of 1.67 points to 3,609.79, a 0.05 percent gain. The FTSAE Eurofirst 300 index jumped 0.03 percent. On Thursday, equities suffered the largest one-day drop since late June. On Friday, the MSCI’s road emerging equities lost 0.5 percent.

Friday’s economic data from the US was less than  encouraging.

On Thursday, a report indicated rising confidence among American single family property owners. The confidence level struck an eight-year high. However, the rapidly rising long-term interest rates has taken a tool on the resale marketplace.

New start for single family homes dipped 2.2 percent in July. However, starts for two-family home spiked 26 percent, completely reversing a downturn in June. July permits for multi-family homes increased by 12. 6 percent while approvals for single family construction slumped 1.9 percent. Overall, July permits climbed to 943,000 units, slightly below projections of 945,000. Housing starts reached an adjusted rate of 896,000 units.

The residential marketplace and new construction is one large factor in projections by JPMorgan and others that growth in the third quarter will reach 2.7 percent.

The overall consumer index reading from the Thomson/Reuters/University of Michigan survey slipped to 80.0, slight underneath July’s six-year high of 85.1. The August reading was the lowest in four months.

Currency Markets

US Treasuries have been volatile. Sparked by surges in British sterling and in the German bund, US notes have been erratic. The benchmark 10-year bond has risen by 1.6 percent since May. On Friday, the 10-year Tresaury was down 25/32 with a yield of 2.8564 per.

The climb in yields drove the dollar up against major currencies. Emerging currencies continued to slide. India’s rupee touched a record low a 62 per dollar. Year-to-date losses are 11 percent. The dollar rose to 97.62 yen. The euro slipped 0.1 percent to $1.3328.      

Muddled messages from the Federal Reserve and a sharp downturn in China’s manufacturing sector and in consumer confidence, sent global equity markets into a tailspin in overnight trading. Better than expected employment numbers in the US brought some stability back as the DJ average rebounded from a triple digit losses at the open. For the week ended May 11, 2013, claims for state unemployment benefits after the first week dipped by 112,000 to 2.91 million recipients, the lowest number of claimants in five years.

Japan’s Nikkei share index .N225 dipped 7.3 percent overnight following data from China’s manufacturing sector and news that the euro zone’s extended pattern of contraction looked more ominous. The Nikkei index had been up a stunning 45 percent this year.

Japan’s newest easing initiative has driven the value of the yen down and led to a very liquid economy that is sputtering for growth. Japan’s profits and growth are stagnant giving reason to question the fantastic gains in equities. It is increasingly clear that global markets are reliant upon quantitative easing that in many ways outweighs output.

Tobias Blattner, a European Economist at Daiwa Capital Markets, told Reuters; “All the global developments we see in the markets right now are purely liquidity-driven, they are no longer underpinned by fundamentals. We must learn to live with that kind of volatility.”

Yen and Euro Rise  

Analysts appeared confused by Bernanke’s statements before Congress. During his questioning, markets slipped immediately. After the Q&A following the Congressional hearing, markets recovered. However, the minutes of the Federal Reserve showed support for reducing Fed’s aggressive purchasing policy if certain factors came into place.

Bernanke told Congress that growth hit 2.5 percent during the first quarter and that employment was encouraging but still well below acceptable levels. He also explained that inflation was steady at about 1 percent, half of the red flag milestone set by the Federal Reserve. Inflation has benefited from reduced energy consumption and pricing.

The dollar-yen dipped as low as 1.01.45 before rallying to 101.68, a 1.4 percent fall from Wednesday’s levels. The euro also made headway against the dollar, trading at $1.2894, a 0.3 percent gain for  the day.

Euro zone weakness is weighing heavily on global manufacturing.

Bernanke Leaves Analysts On Edge

One of the purposes of the Fed’s purchasing program is to increase wealth. Equity markets have been big beneficiaries from this strategy. Americans are saving at the highest rates in 4 years. Recent good news from the National Association of Realtors points to gradual recovery in the housing market.

Bernanke explained the impact of the Fed’s $85 billion monthly bond purchases;  “Monetary policy is providing significant benefits. Monetary policy has also helped offset incipient deflationary pressures and kept inflation from falling even further below the (Fed’s) 2 percent longer-run objective.”

The Federal Reserve’s minutes showed that several board members advocate reducing the purchasing program as early as June. This sent tremors through the equity and bond markets. The benchmark 10-year treasury bond climbed over 2 percent for the first time since March. Japan’s 10-year bonds climbed to 1 percent.

The 17-nation euro zone output shrank by 0.2 percent in the first quarter 2013 creating the longest recession in the bloc’s history. Projections for the future are not promising. Analysts project slight growth in late 2013 but no significant upturn until 2015. The first quarter contraction marks the sixth consecutive quarter that euro zone GDP has contracted.

France which has been teetering on the edge of a recession finally crossed the line and suffered a 0.2 percent downturn, equaling its output in the fourth quarter 2012. Unemployment in France is at record levels.

France joined the list of euro zone economies in recessions. Finland, Cyprus, Italy, The Netherlands, Portugal, Greece and Spain are solidly entrenched in recessions. Italy and Spain, the euro zone’s third and fourth largest euro zone economies, have endured seven consecutive quarters of negative growth.

The new data pushed the euro below the 1.29USD mark. The currency fell to six-week lows and shows little hope for recovery. The trend of the euro and the anemic growth in the bloc may prompt the ECB to engage in more aggressive monetary easing initiatives.

Last week, the ECB cut interest rates to historic lows. However, Mario Draghi, ECB president, has said that he is not opposed to another rate cut.

Austerity vs. Growth

To a degree, German led calls for austerity have stabilized the euro zone treaty. But, most of the nations want to shift the focus to growth. Euro zone unemployment is estimated to include more than 19 million workers.

The consensus is that the natives of the euro zone have been pushed about as far as they can go. France has been an advocate for growth and has marked the formation of a Europe-wide banking supervisor as an important step in the region’s recovery. German finance minister Wolfgang Schaeuble and Chancellor Angela Merkel have opposed this new initiative fearing that Germany would have to bear the heavy load.

On Tuesday, Schaeuble appeared to soften his position, suggesting that the new, broader banking union could be structured by June. A second aspect of this initiative would call for identification of banks that need to be closed. Schaeuble told French finance minister Pierre Moscovici that the new banking union was a “priority object.”

Germany, always the pillar of the euro zone, is facing its own manufacturing, export and GDP problems. GDP was revised from negative 0.6 percent in the fourth quarter 2012 to 0.7 percent. Germany narrowly avoided falling into recession by posting a 0.1 percent gain in the first quarter 2013. Despite its tempered growth, Germany enjoys the lowest unemployment rate in years.

Liquidity Driving Equity Markets

The euro is off 2.3 percent in May, hitting 1.2883USD in overnight trading. The dollar rests comfortably in the 102 range against the yen. The ECB is likely to consider another rate cut before the end of the year. The dollar reached 102.63 yen overnight.

Meanwhile, the Federal Reserve and the Bank of Japan continue to pour money into easing programs. The weak yen is very liable to cause more export stress in Europe.

The UK has been damaged by the weaker euro and the stronger pound. UK exports have lowered to Europe but have increased to other markets like Southeast Asia and Africa. Outgoing Bank of England head, Mervyn King hinted that the BoE may be softening its easing program shortly. King put forth the first positive outlook for the UK since the outset of the financial crisis. Britain has been successful encouraging small business growth but still fights high unemployment and a slumping housing market.

All eyes will be on Italy’s upcoming 30-year bond auction after Spain had a successful 10 billion euro sale of its 10-year bonds on Tuesday. After Fitch Ratings upgraded the nation’s sovereign debt, a positive accomplishment, Greece’s 10-year bonds surged in Wednesday’s auction. Greece is no longer viewed as a country about to leave the euro zone, a credit to the tough love imposed by Germany.

Another Day of Betting on the ECB & QE3

After a downturn at the open, US equity markets turned positive on news from the euro zone and the European Central Bank (ECB). The DJI closed up 100.51 points while the Nasdaq Composite Index ended the week at 3,089.79 and the S&P 500 climbed up enough to close at 1,411.72. On the whole, US equities are still bullish.

Despite news from the Fed that stimulus was unlikely at this time, an encouraging development in the debt ridden euro zone outweighed the Fed’s Thursday report. Investors have been leaning heavily on the Federal Reserve and appear to be anticipating the controversial QE3 stimulus. The market opened on the downside in anticipation of a selloff due to Bernanke’s announcement.

Fed Chairman Bernanke does not mince words.  After his report on Thursday, equities all turned lower. After meeting with Greece’s President, Antonis Samaras, on Friday and talking with France’s Francois Holland on Thursday, Chancellor Angela Merkel announced that Germany and France were in agreement that they wanted Greece to remain in the euro zone. Merkel stipulated that she would abide by decisions made by the troika of international investors. Once again, the Chancellor stressed that Greece must meet its commitments before any infusion of any further financial aid could be made. Merkel falls short as credible. Without easing her position, it is difficult to see how the euro zone can escape a catastrophe.

Recently rated the most powerful woman on the planet, Merkel’s political future is in doubt. In any case, global markets did not react to the chancellor’s statement.

However, later in the day, ECB President Mario Draghi announced the central bank was contemplating setting targets in another bond-buying spree that would be deigned to control euro zone borrowing costs. The focus of this initiative will be to stabilize Spain’s volatile and unsustainable borrowing rates.

In looking back over the week, perhaps the most unnerving occurrence is Finland’s development of a course of action to withdraw from the euro zone. This would be a voluntary withdrawal and more importantly a signal that other members, including Germany, may be contemplating ending their participation in a broken model.

Draghi has been high profile in stating his case for more ECB easing. It is not certain how his initiatives will be received by his member nations. The ECB President will speak at the G20 in Jackson Hole next Saturday.

Investors still hold out hope that the Federal Reserve will come through before the end of the year, but there does not appear enough negative data to justify what could be a final push to decrease unemployment. New factory equipment purchased was down in July but production was up. The unemployment rate edged up to 8.3 percent. There is no doubt that uncertainty about the euro zone is undermining the US economy.

The US Congress, with its newest approval rating of ten percent, has been called upon by Congressional Budget Office to not repeat the horrific battle about extending the deficit come December. There is little reason to believe that this Congress will put their jobs on the line prior to Election Day.

No matter how you view the politics of the time, Congress, not the President, drives or stops the engine known as the US economy. Two years ago, Republicans used the deficit to force the President’s hand and extend the Bush Tax Cuts, which will revert to pre-Bush tax rates on January 1, 2013 unless a compromise is reached.

The Congressional Budget Office (CBO) warned Congress that if arrangements were not made to avert the $500 billion in tax hikes and pre-arranged budget cuts, the US economy will plummet into another recession in the first half of next year. The CBO further warned that unemployment would rise to 9.1 percent during the first quarter of 2013. It is crunch time for the US economy and nobody is home minding the store. Whoever the President is will be of little consequence unless the House and Senate have similar majorities to the President’s.

After months of speculation, the Bank of Japan (BOJ) has finally intervened in the currency markets. As the plummeted towards a fresh low against the Dollar, the BOJ swiftly entered the market, driving the Yen up 2% instantly. On the day, it finished 3% higher against the Dollar.

Over the last few weeks, Japan had been inching slowly towards intervention. [In fact, I was prepared to write a post yesterday about intervention being imminent, but that is neither here nor there…] The Finance Minister, Governors of the Central Bank, Members of Parliament, and even the Prime Minister himself had started to become increasingly vocal about the Yen’s un-halting rise, and the need to control it. It had already touched a 15-year high, and was only 4% away from it’s all-time low. With rhetorical intervention and its easy monetary policy failing to sway investors, the Bank of Japan sold an estimated $20 Billion worth of Yen on the open market.

By no coincidence, the intervention was carried out only one day after a Parliamentary vote to see whether Naoto Kan would be replaced as Prime Minister. Having defeated Ichiro Ozawa and survived the challenge, Kan evidently was determined to make good on his promise to rescue the economy from the brink of another downturn. (Only a few days earlier, he admitted, “We’re conducting various talks, so other countries won’t say negative things when Japan acts. We’re studying now various scenarios, examining possible responses from markets when we take a decisive measure.”)

Reaction to the intervention has been mixed. On the one hand, the fact that the BOJ waited so long before stepping in is evidence that this measure was taken out of desperation. According to Billionaire investor George Soros, “Japan was right to act to bring down the value of the yen. ‘Certainly, they are hurting because the currency is too strong so I think they are right to intervene.’ ” Politicians and policymakers, on the other hand, were not so kind. One US Senator called the move “disturbing” and Jeane-Claude Trichet, President of the ECB, said it was “not…appropriate.”

From these snippets, then, it’s clear that the intervention is being conducted unilaterally and lacks any support from other Central Banks. Thus, if the BOJ is to continue selling the Yen, it will do so alone and perhaps even under the open contempt of other Central Banks. At the same time, it appears to have some credibility with investors, who may back off the Yen for the time being. That’s because the BOJ is trying to make owning the Yen as unattractive as possible, by driving down interest rates and attempting to spur inflation. Whether investors will take the hint and stop and return to using the Yen as a funding currency for the carry trade is still unclear. (Despite unraveling significantly over the last two years, the Yen carry trade may still exceed $500 Billion). Japan also has to contend with China, which has been putting upward pressure on the Yen by buying Japanese bonds.

For that matter, it’s not even clear whether the BOJ will continue to intervene. Perhaps it just wanted to send a message to investors by showing that it can weaken the Yen any time it wants. Besides, a protracted campaign to hold down the Yen would be expensive and doomed to failure over the long-term, as the BOJ learned the hard way in 2003-2004 and has probably been reminded of by the Swiss National Bank’s recent failure to weaken the Franc. On the other hand, the BOJ needs to show investors that it is serious, and a “shock and awe” intervention campaign is probably the only real way to achieve this.

Either way, I think it’s fair to say that those who bet on the Yen do so at their own peril. While I don’t think the Yen is suddenly going to return to 100 JPY/USD, the fact that my personal reserves are not nearly as vast as those of the Bank of Japan means I’m not inclined to bet on it…

The rally in the Pound, which lifted it 10% from trough to peak, appears to be fizzling. The Pound is already down 3% in the last two weeks, and is trending downward. It now stands at a four-week low against the Dollar.

Looking back at the Pound’s two-month rise, it’s not hard to understand why it was unsustainable. You can see from the charts below that there was a strong correlation with the Euro and the S&P 500 over the same period of time. This suggests that the Pound rally was less a product of changing fundamentals and more due to a sudden decrease in risk aversion.

By no coincidence the rally in equities, the Euro, and a handful of other proxy vehicles for risk, all came to and end at the same time as the Pound. In a nutshell, the markets are back to focusing on fundamentals. Namely, the risk of a double-dip recession, combined with a lack of resolution in the Eurozone debt crisis is causing investors to think twice about making bets that entail any kind of risk.

In this regard, the Pound is especially vulnerable. On the economic front, the UK economy only grew by 1.1% in the second quarter, with economists predicting only modest growth for the year. According to an economist for the Bank of England, “It would be ‘foolish’ to rule out a renewed downturn.” Evidently, his bosses agree: “The Bank of England last week said growth will be weaker than it forecast in May, citing “continuing fiscal consolidation and the persistence of tight credit conditions.”According to a recent poll, almost half of British households are pessimistic about the country’s economic prospects in the near-term: “The proportion of pessimists is marginally lower than in July, but is higher than in any other month since March last year.”

Ironically, the efforts of the British government to curb spending and cut the deficit are perceived as making matters worse. Since these measures won’t be offset by lowered taxes, they will directly lead to lower economic growth. Given that both the Pound and UK bond prices are rising (implying an increased risk of default), I think this reinforces the point I made last week about the markets not caring at all in this economic climate about increasing national debt.

The icing on the cake is inflation. A British think-tank made headlines by predicting that the UK economy will emerge from recession next year, “But once recovery is under way, he thinks, then the Bank of England’s quantitative easing scheme, which pumped £200 billion into the economy in the wake of the credit crunch, will have terrible consequences.” Specifically, the think-tank is forecasting inflation of 10% and a benchmark interest rate of 10%.

For now, this remains a distant prospect, and analysts are focusing on the fact that the economy will probably re-enter recession before it can officially exit from it. As for the Pound, forecasts are not optimistic: “Bears in a Bloomberg survey of strategists outnumber bulls 29 to 12, while TD Securities in Toronto, the most-accurate forecaster in the six quarters ended June 30, has the lowest estimate, predicting sterling will depreciate 15 percent versus the dollar by year-end.” According to the most recent Commitments of Traders report, institutional investors were still net long the Pound as of August 10. Futures prices, meanwhile, have moved in lockstep with spot prices, which suggests that futures traders are still waiting for more data before they weigh in on the Pound.

Personally, I’m having a tough time coming up with a prediction. I tend to agree with the characterization of “the foreign exchange markets post-crisis as a beauty parade with ugly contestants.” In other words, all of the major currencies are currently plagued by poor fundamentals. It’s hard to say that the Pound is in better or worse shape than the Dollar or the Euro. Still, given the way that markets have been trading, a return to (global) recession would not be kind to the Pound.

Ever since March 2009, the relationship between the dollar and U.S. equities has behaved like similar ends of a magnet. When equities rose, the dollar fell and vice versa. Analysts blamed the role of the government’s lenient credit policy for this inconsistency.

Now, other factors have come into play. The dollar and equities seem to be reacting similarly to national and global economic events. On the national scene, there are signs that employment is stable, trending upwards and definitely has the attention of the Obama Administration.

While the necessary spirit of cooperation is at record lows in Washington, there appears a hint of progress.  The $15 billion jobs bill is progress and consumer spending is on the rise. Meanwhile, more small businesses have indicated a willingness to hire. 

The Federal Reserve had such favorable credit terms that the effect was to drive the dollar down and equities up. Basically, investors were using a currency that cost virtually nothing to acquire undervalued equities. It may have been and still may be a false economy, but it stemmed the tide at a critical time.

With recent statements from Fed Chairman, Ben Bernanke, the future of the dollar looks good. Bernanke has outlined a series of actions designed to strengthen the currency. Interest rate hikes, a cessation of purchasing distresses assets and certain progressive credit reforms are all positive steps for the dollar.

Timing is Everything

The Fed’s changes have been timely. As the euro zone tries to untangle the financial chaos in Greece, the euro has suffered a significant downturn. In 2010, the euro has dropped 4.8 percent against the dollar and a whopping 7.6 percent against the yen.

On Monday, French President Nicolas Sarkozy said there are plans to rescue Greece. He added that if the fiscal crisis in Greece worsened the euro would be hurt. Currency trading has been light as investors are waiting and watching Prime Minister Papandreou’s attempts to control the damage.

But, Greece may well be just the first block in the tenable euro zone to tumble. Spain may be next with Italy, Portugal and Ireland in the wings. With talk of more quantitative easing in Great Britain and a fair amount of intense disagreement between the liberal and conservative factions in England, the pound is wavering under the pressure.

Australian and New Zealand dollars rose favorably against the dollar on Monday.

In 2010, the S&P 500 is up 2 percent. The dollar has risen 3 percent. Helping the equities markets are a new infusion of merger and acquisition activity. The Options Exchange Volatility Index (VIX) is a highly regarded index indicating markets attitudes. The VIX has fallen below 18 percent and is trending towards the year’s low.

As the Oracle of Omaha suggested, things are looking up and it is a good time to invest, in the dollar and in equities.

On Thursday, The Federal Reserve offered a generally favorable assessment of the nation’s economy as the Federal Open Market Committee (FOMC) supported holding the central bank’s interest rates steady in a 9-1 vote.  Kansas City Federal Reserve Bank President Thomas Hoeing, who is opposed to the Fed’s sustained exceptionally low interest rate policy, registered the lone vote of dissent.

The FOMC statement lacked assurances about the strength of the recovery, instead offering carefully controlled suggestions of improvement. The pace of the recovery was described as “moderate for a time” and the overall recovery was depicted as “likely to remain weak.”

Addressing the ongoing housing crunch, the body affirmed its commitment to allow the $1.43 trillion program for the purchase of mortgage-backed securities to expire at the end of March.  Analysts have expressed fear about the cessation of the program that has bred some stability into a tenuous marketplace.  The Fed pulled back from its more positive forecast about inflation saying price growth will likely remain subdued.

The Markets Reacts

The U.S. dollar reacted positively to the Federal Reserve statement pushing the euro below $1.40.  Hoenig’s dissenting vote was interpreted as an open door to a tightening of monetary policy.  The majority of primary dealers expressed the view that to combat inflation, the Fed would begin to raise rates this year.

After a sharp downturn last week, the equity markets seem to be stabilizing.  Federal Reserve Chairman Ben Benanke’s nomination is expected to be voted upon in Congress on Thursday.  Equity markets have stumbled as his confirmation has become less certain.

The Federal Reserve issued other definitive statements.

• The economy grew in the 3^rd quarter of 2009 and is presumed to have grown more aggressively in the fourth quarter.
• Consumer spending remains subdued.
• The real estate market is showing signs of renewed weakness.
• Several emergency lending programs will be halted as of February 1, 2010.
• Favorable short-term lending to banks will halt in 2010.
• Dollar swapping with foreign central banks will cease on February 1.

On the Street

Traders supported a position that short-term interest rates will increase in the third quarter of 2010.  U.S. short-term rate futures turned lower after the FOMC policy release.  Expectations are that the Federal Reserve will maintain an “ultra loose” monetary policy into 2011.  Futures on federal funds fell to session lows following the FOMC report.

The benchmark 10-year Treasury yield closed at 3.64% or 2 basis points higher than on Tuesday. The yield on 10-year swaps over Treasuries closed at 12.25 basis points, down from session highs of 13.25, but up from the 12.0o on Tuesday.

George Ball, Chairman and CEO of the Sanders Morris Harris Group, drew the following conclusions about the Fed’s two day meeting;

“The most important part of the Fed’s announcement and perhaps the most unsettling for investor’s over the short-term is that they are giving the March end-date to purchases of mortgage-related securities.  That will give us a true test of the strength of that vital marketplace, to see if it can stand on its own without being propped up by big brother.”

Equity markets are rising.  Crude oil is on a tear.  And the euro has everyone worried.  From European central bankers to the regional exporter, even to the U.S. traveler looking at an even more expensive European getaway, people are paying attention when it comes to the Euro.  And why not?  The currency has skyrocketed higher against the US dollar in recent months, making an impressive 20 percent gain since hitting the 1.2500 support back in February.  The scary thing is, the gains may be more to come as the current momentum seems to be bent on some key factors.

Economic Pessimism

Pure fundamental reasoning for the recent downturn has some in the market convinced that further dollar weakness is sure to come.  Although the European economy is down in the dumps as well, the masses seem to be focusing on the growing twin deficits currently held by the U.S.  The same concerns helped to support a higher Euro valuation just five years ago, when estimates had calculated a fiscal shortfall of $700 billion.  Chump change to what experts are now shuddering at when considering the plethora of programs that have been approved by the current administration.  Participants of the era will also scarcely remember falling employment as well.  All in all, current budget deficits will have to be funded by an increasing number of Treasury debt issuance, adding to an already bloated credit bill that is surely to decrease the confidence in U.S. based debt.

Carry Trade Bandwagon

It used to be the Japanese yen that was the butt of all carry trades in the last two to three years.  However, now it seems that the greenback is the funding currency of choice.  It makes perfect sense as the Federal Reserve has made significant cuts to the benchmark interest rates over the last 20 months in order to accommodate the underlying credit markets.  But at what cost?  With benchmark rates at the record low of 0.25 percent, traders will continue to sell the U.S. dollar short, helping out the Euro.  Making it even worse is the fact that U.S. rates aren’t expected to be raised until after all of the other G7 central banks have their turn.  Although expectations were hovering around a 40 percent chance of a 25 basis point increase by the Fed in the fourth quarter, those estimates have dwindled and placed a higher likelihood of that happening at the tailend of the first half 2010.

Dollar Doldrums: Central Banks Want Out

Additionally, central banks have played their part in rumors and threats as entities in all parts of the world have begun to talk the dollar down.  Earlier this summer, BRIC nations complained about their exposure to the dollar with Russia leading the way for a supranational currency or preferential trading of special drawing rights backed by the World Bank.  All of this talk of currency conversion has done nothing but increase already nascent speculation that a massive Euro conversion may happen as nations attempt to diversify out of U.S. dollar based assets.  This is of particular interest as three of the five aforementioned nations have risen up the currency reserve ladder (#1 China, #3 Russia, #5 India), with the fourth (#8 Brazil) not too far behind.  As long as there remains the underlying discomfort between the greenback and these nations, there will be a supported preference for anything other than U.S. currency.

The Monkey Wrench

Given the recent facts and trends, Euro strength looks to be here to stay.  Even if European Central Bank President Jean Claude Trichet begins his dutiful jawboning of the detrimental effects of a stronger currency, speculators are likely to keep pressing the currency higher.  The only caveat seems to be in the form of an earlier economic assessment of the Euro region.  Given the fact that interest rates remained relatively high in the area, economic growth may be slow to come.  The slower growth will likely keep European nations behind the current recovery and force policy makers to drag heels when it comes to raising rates in the near future.  Should this economic stalling actually take place, the current euro momentum may be placed in jeopardy.

Britain’s newspaper, The Independent, reported on Tuesday that Gulf Arab states, Japan, Russia, China and France were negotiating behind the scenes to replace the U.S. dollar with a basket of currencies in future oil trades.  Citing unnamed Gulf Arab and Chinese banking sources, reporter Robert Fisk’s articles caused a sharp upturn for the Euro, which edged as high as $1.4749 in European trading before the report was discredited.

The tenuous dollar still gave way to the Euro, which settling at $1.4701 against the dollar.  The weaker dollar and anticipation about Wednesday’s U.S. earnings reports sparked another strong rally in U.S. equity markets.  By Tuesday afternoon, Gold cleared the $140.00 barrier and hit an all-time high as U.S. equities rose another 131 points.

Fisk’s story set off a firestorm of public and private reaction.  The report was quickly denied by Algeria, Russia, Saudi Arabia and the United Arab Emirates.  Muhammad al-Jasser, Saudi Arabia’s head of the Central Bank labeled the report, “absolutely incorrect.”

Russian finance minister Dmitry Pankin added; “We did not discuss this at all.”  While the story seems baseless, there is a general uneasiness about the reeling dollar.  Stretched by abundant forms of quantitative easing and with overwhelming trade and budget deficits, the American dollar remains under pressure.

Meanwhile, other economies appear to be forging their way out of the recession.  The concern is that the U.S. is headed for another downturn before the recovery gains a foothold.

Fisk’s report mapped out a strategy that crude oil trading would convert to a basket of currencies including the Japanese yen, the euro, the Chinese yuan and a new, unified currency of the Gulf Cooperation Council within nine years.

IMF in Istanbul

On several occasions, Russia and France have publicly encouraged a shift away from the dollar for oil trading.  The currency’s volatility has also caused China, the holder of the largest foreign exchange reserves, to support a change.

While the talks among IMF members have been addressing global trade imbalances, the key to sustained balance may well be the further devaluing of the dollar.  David Moore, a commodities expert with the Commonwealth Bank of Australia explained; “I don’t think we will see much concrete action out of such discussions because even when the dollar is weak, it doesn’t mean that commodities are undervalued.  In fact, when the dollar weakens, commodity prices tend to increase by a higher ratio.”

Such a conversion presents many practical issues.  Many financial ministers agreed that it is already difficult to convert to a single currency much less a handful of options and conversion rates.

Several analysts countered by pointing to Iran as an example of a country that has been able to make a fairly seamless transition away from the dollar.  However, most analysts thought the process more laborious than worthwhile.

Strong Message From Australia

The Reserve Bank of Australian (RBA) sent a clear message that the country has emerged from the recession by increasing its cash rate by 25 basis points to 3.25 percent.  The Bank indicated more increases were in the offing.

The Australian dollar immediately jumped to a 14-month high.  Asian currency banks seemed to be ready for strong moves as several economies moved to pull back from quantitative easing. 

The surprising move by the RBA made Australia first Group of 20 bank to hike rates.  The bank indicated a desire to increase rates to 4 percent over the next few quarters and hopes that rate would reach 5 percent by 2011.

The Australian economic recovery and real estate markets have been bolstered by the country’s strong banking presence.  Treasurer Wayne Swan said: “The Australian economy is outperforming other advanced economies and I guess many economists will see the decision today as a consequence of economic recovery.”