The European Central Bank must be tired.

After pumping tens of billions of euro and dollars into its financial system over just the last two weeks, the ECB couldn’t muster enough energy to cut rates last Thursday. The ECB left their benchmark lending rate sitting at 4.25% after they concluded their policy meeting yesterday morning.

Considering major risks of bank failures rising to the surface in Europe, a handful of investment banks took the opportunity to make their predictions yesterday. Those predictions: The ECB will cut rates before the end of the year.

Well, so far the bank analysts who took a swing at the ECB’s plans are now 0 for 1. But let’s not count them out just yet…the ECB meets plenty more times before 2008 comes to an end.

But if you’re banking on a rate cut to further weigh down the euro, you may not have to wait for the ECB to officially lower interest rates. The situation in Europe (though the ECB’s monetary policy remains firm) will likely pressure the euro through year-end. The market is pricing this in already.

And if the dynamics supporting the dollar really gain momentum, a serious capitulation among dollar bears could extend dollar-strength well into 2009 and bring the euro all the way back down to earth.

Whatever your personal opinion is about this proposed bailout, you can’t deny Monday’s negative vote has smacked the stock market with a hammer.

But then the Dow sprang back, posting a gain of almost 500 points yesterday and recovering almost all of its losses from the one-day freefall. But no one’s lighting Cuban cigars just yet, as we have another vote in the works for today.

So what can you do? Where can you run and hide when the market experiences confusion like this? After all, it could be days, (more likely weeks) before the stock market settles down again.

Answer: You dive into a few key risk-adverse investments, including specific currencies, as fast as you possibly can. In fact, I call these investments “rip cord currencies” because you should only buy them when the stock market is skydiving.

First of all, you won’t find a better “rip cord” investment than the Japanese yen. The yen is the ultimate risk-adverse investment. It responds faster and more violently to stock market drops.

The yen has a low interest rate yield, so traders tend to pass this currency up for higher-yielders when markets are calm. But as soon as markets start to drop, traders rush back into the yen, to take whatever interest they can get.

Along with the yen, there’s another low-yielder that tends to prosper during rough economic times. Of course, I’m talking about the “safe haven” currency - the Swiss franc. For years and years, gold partially backed the franc, so traders ran to it as markets sank. Well, even though it’s not backed by gold anymore, traders still run to this low-yielding currency in times of uncertainty…out of habit.

Bottom line: Cling to the low yielders like the yen and the franc as markets hit the drop zone.

Paulson, unlike Congress, wants to throw everything the United States has into fighting the deflation afflicting American banks right away. And Bernanke - a scholar on monetary policy - understands the cost of inaction from examples like the Great Depression (when the Fed failed to address deflation until the latter half of the 30’s) and Japan’s lost decade.

History strongly suggests that any delays or lack of sufficient funds committed to blasting away at deflation can be painful. So in my mind, one powerful bailout could potentially help us find the bottom of this crisis at least in the short-term.

Instead, dollar-cost-averaging for the long-term is a great value-based strategy now, especially for younger investors. For everyone else, stick to income-producing or equity-linked investments that spin off income. Also, as credit markets eventually stabilize, look to huge values in investment-grade corporate bonds now yielding almost 7%.

This is not the time to bet the farm on stocks. Deflation - the environment of rapidly falling prices and the contraction of lending - will continue to inhibit earnings growth and domestic consumption for the next several months or longer.

Deflation is here and it’s real.

There’s something you should know about the Aussie dollar. It’ll help you understand how investors are treating risk following last night’s incredible session on the Dow.

The AUDJPY has been a risk appetite indicator since summer 2006. This popular carry trade is strongly correlated with the Australian stock indices. The Japanese currency is negatively correlated with world equity indices. Stocks go down, yen goes up. They move into opposite directions.

When investors are risk-seeking, they go long carry trades (long AUDJPY for example) where they win on both interest rates differential and FX rates. Those gains in cash are invested on the stock markets. When investors become risk-averse they cut their carry trade positions. This means they have to sell their equity lines to have some cash to face their potential losses on the currency side.

So a clear view of the FX markets can be very useful for the equity investments.
Yesterday Wall Street crashed by 6.83% for the Dow Jones and by 8.50% for the S&P 500. In the same time, the AUD/JPY fell by 5%.

The weekly chart below shows the correlation between the AUD/JPY (in black) and the $&P/ASX 200 (in red) since 2000. This correlation has been very strong since 2003 and the beginning of the bullish trend on the equity markets.

Click to Enlarge

The AUD/JPY has been retracing its 7-year bullish trend (points A and B on the chart). Two first intermediary supports have been hit in March and September this year (points C and D) and constituted an opportunity for traders to sell back the Japanese currency. These supports were the 38.2% and 50% Fibonacci levels.

The crash today on the S&P/ASX 200 has already driven the AUD/JPY lower than 82, the 50% Fibonacci ratio. The next target is therefore around 75.50, which is the last significant correction level of the 7-years bullish trend.

The Momentum and MACD indicators are bearish. Risk-aversion is soaring. Those elements argue consequently for a further Yen rise.

Yesterday the currency pair closed at 83.51. There is another 10% decrease potential to reach the target of 75.50. Tomorrow we will have a look at the S&P/ASX 200 technical forecasts…and find out where this market is heading.

The flip side of the coin is that the share market might not bounce. In that case, your best bet is still shiny and yellow. Gold bullion has been doing the opposite of shares. Rising when the bailout looks shaky. Falling when it looks inevitable.

If history is our teacher, it tells us that the dollar does respond to any crisis for a few months or so typically after the economy hits another rough patch. However, afterwards, it reverts back to the trend at hand.

If it went into the crisis in a downtrend, then it goes back into it again. And if it went into the crisis in an uptrend, then it tends to revert back to that uptrend too.

If history is any indication, then it’s very possible the dollar will simply continue the downtrend it’s been in for the past six years: crisis or no crisis.

But due to additional factors - namely the dollar being at a 30-year low point at the beginning of this predicament - I don’t think it’s going to be a very clear downtrend. At least not in the short-term.

I see the dollar ‘ranging’ (Forex speak for going nowhere at all) over the next few years, much like it did after the S&L crisis, as you can see below.

Bank Failures Mean the Bumpy Ride Will Continue

This is what I believe may happen this time as well. However, on a year-over-year basis, it won’t feel like a wide range. It will feel like very strong, sharp uptrends. It’s only when you look back on this era over 10-15 years that you may see the dollar ranged for several years after - what shall we call it? Perhaps - “The Bailout Crisis of 2008.”

The Reserve Bank has moved to try and solve a shortage of US dollars in the Asian area by joining a swap arrangement involving the US Federal Reserve.

The shortgage of US dollars outside the US has continued despite moves by the Fed to inject more into the global economy.

The RBA has joined central banks from Norway, Sweden and Denmark in setting up a US dollar swap arrangement with the Fed totalling $US30 billion and lasting until at least the end of January 2009.

The RBA said currency swap lines have been set up between itself, the Fed and the Denmark, Norway and Sweden central banks - Danmarks Nationalbank, Norges Bank and Sveriges Riksbank.

“The swap serves to alleviate a shortage of US dollar liquidity which has affected market participants around the world including in the Asia-Pacific time zone,” the RBA said.

That’s part of a global shortage which saw short term rates in Europe for US dollar loans soar overnight to their highest levels since January.

At the same time, rates on US Government three month T-notes again fell sharply as banks and othert investors chased security while the $US700 billion bailout plan was being debated in Washington. 

The rates are not as low as they were a week ago when markets frayedf, but they are heading that way, indicating a sharp contraction in the availability of US dollars.

Hence the series of US dollar swaps the Fed has conducted in the past week with central banks around the world.

The US dollars will be made available, against collateral, to local market participants by the RBA through an auction, the first of which will happen tomorrow.

The term of the initial swap will be 28 days.

Subsequent auctions will depend on market conditions.

The RBA did a $1 billion US dollar swap last Thursday to try and pump extra American dollars into the market to accommodate demand from fund managers and others looking for greenbacks for end of quarter transactions.

“These facilities, like those already in place with other central banks, are designed to improve liquidity conditions in global financial markets,” the RBA said in a statement that was released simultaneously with a similar notice from the Fed.

“Central banks continue to work together during this period of market stress and are prepared to take further steps as the need arises.”

The Fed said in its statement that the swap lines it will have with the RBA, Denmark Norway and Sweden central banks are a $US30 billion addition to the $US247 billion previously authorised temporary swap arrangements with other central banks announce earlier this month.

“In sum, these new facilities represent a $30 billion addition to the $247 billion previously authorized temporary reciprocal currency arrangements with other central banks: European Central Bank ($110 billion), Bank of Japan ($60 billion), Bank of England ($40 billion), Swiss National Bank ($27 billion), and Bank of Canada ($10 billion),” the Fed said in its announcement.

In a separate announcement the RBA said that it will establish a domestic term deposit facility to further enhance the flexibility of domestic liquidity management operations.

“To further enhance the flexibility of its domestic liquidity management operations, the Reserve Bank will offer a short-term deposit facility (to be known as RBA Term Deposits),” it said.

The facility will be available to institutions holding an exchange settlement account and to authorised deposit-taking institutions.

The RBA will conduct auctions at which eligible institutions will be able to bid for deposits.

The first of auction, for a deposit of 14 days, will be held next Monday, September 29.

It will be run in addition to the current system of injecting funds each morning via repurchase deals involving government bonds and other securities as well as asset backed commercial paper and residential backed mortgages.

The offer to take short-term deposits from banks and financial institutions is going to be aimed at mopping up liquidity from banks, as part of its domestic operations.

Analysts said the bank is trying to attract some of the excess overnight funds that banks are holding as they refrain from lending to each other at the moment because of the credit crunch.

That has led to a spike in term-money rates, especially in three month bill rates. They are above the rates for 180 day paper: 7.43% versus 7.34%. This has been happening since the start of the month

The RBA yesterday $815 million in repurchase agreements, compared to an estimated cash deficit of $612 million. It drained a small amount on Tuesday, but resumed pumping in extra cash on yesterday as interbank lending rates remained high.

Once you add currency plays to your portfolio, you’ll quickly discover currencies have an advantage over several other markets. For starters, currencies can produce large gains in a relatively short amount of time, unlike bonds. Also, certain currencies perform well during both recessionary and recovery periods, as I mentioned.

In fact, we can be smack dab in the middle of a recession and certain currencies will still perform well. Don’t believe me? Look at the markets right now.

Usually the savvy investors switch to commodities when stocks are falling. Earlier this year, commodity investors made a killing when they dropped their stocks for long-term commodities. However, those same investors got slaughtered two months ago when commodities plummeted. As those investors learned, there are times in the economic cycle when BOTH stocks AND commodities are going down - and we’re in that time RIGHT NOW!

So what’s left? How do you buffer the volatility and help diminish draw downs to your portfolio in times like these? You buy the currencies that perform well during bear markets or more specifically low-yielding currencies like the Japanese yen and Swiss franc.

Remember: Since currencies are always traded in pairs, you just have to look to the currencies that might not have seemed worthwhile during times of growth and expansion. Currencies like the yen - whose low interest rates encourage institutions to borrow it - and the Swiss franc are excellent ideas in markets like this one

Currency traders like to say that currencies are always in a “bull market.” That’s partially true. What’s closer to the truth is you can always find at least one currency that’s outperforming the stock, commodity and bond markets at any given time.

For example, over the past weekend Lehman’s, AIG’s and Merrill Lynch’s troubles took a bite out of the dollar’s performance. But while the dollar dipped, two currencies continued to rise - including the Japanese yen and Swiss franc.

This is pretty typical of currencies during this type of market…

Traditionally, there are currencies that prosper during tough times, even during recessions and depressions. These “recessionary” currencies are beaten down during recovery periods.

Traders scorn these currencies when other markets are soaring because no one wants their “paltry interest” and smaller growth, when they can get higher returns elsewhere.

However, when markets start to fall, currency traders grab these currencies with both hands to save their portfolios. That’s exactly what happened this weekend. The so-called “weakest currencies” paying paltry interest rose, while the high-yielding currencies like the Australian and New Zealand dollar sank

To recap: During stock bull markets, currency investors are busy buying up high-yielding currencies and continually selling low interest yielding currencies. But when bad times hit, currency investors quickly trade in their high-yielding currencies for the safety of the ‘beaten-down dog’ currencies like the Japanese yen and Swiss franc.

In the midst of all of this market turmoil, our old friend during risky markets - the Japanese yen - is still rising. You can pair this gem with almost any currency in the world right now - especially the British pound.

The Japanese yen has been beating out every single one of the top 16 or so currencies. So this is the biggest place that money is running to right now.

Why is this happening? It’s not that Japan’s economy is so strong. In fact, Japan may be entering into a recession as we speak. So what’s going on? In the past, as stock markets grew strong and volatility stayed out of the markets, investors around the world bought high-yielding currencies with borrowed money in the lowest yielding currency in the world, the Japanese yen (0.5%).

Many of these currencies reaped 6-8% a year. As an investor, all you had to do was pay between zero and one half of 1% if you borrowed yen. When you add a bit of leverage to these positions, you reap even greater returns just by borrowing low and reinvesting those funds. This strategy worked for years during calm, cool, and collected financial markets.

However, as we know…since about a year ago, the markets have taken a turn for the worse. We’re now in a high-risk, volatile market. That’s obviously not conducive to this type of currency investing called “carry trading.”

So as these positions are closed out (or as they say in the industry - unwound), they sell the higher yielding currency like Aussie or New Zealand dollars or like the euro or pound and have to pay back that loan of yen. When they do this, they are “buying back” yen which causes the yen to pop up.

It’s almost like a short-seller in stocks covering his short-sell by buying back the shares to close the position out.
Long story, short: As long as the turmoil lasts, the yen will prosper. Traders will continue to unwind positions as many are either margin-called or flat-out scared out of their positions.

The Rate Cut That May Cost You Money
The latest news from the Australian Bureau of Statistics (ABS) was that the unemployment rate had fallen to 4.1% from 4.3% the previous month. These numbers were on a seasonally adjusted basis.

Source: ABS

The Reserve Bank of Australia (RBA) jumped too soon. That is one reaction after seeing the latest unemployment numbers from the ABS.

The other reaction is that the RBA has accounted for this because it wants to avoid putting the economy into recession. The argument would say it is not worrying from an inflation perspective either.

Consumers Expect Inflation Rate to Fall
At the same time the Melbourne Institute released its survey of consumer inflation expectations. It shows that consumers are feeling quite positive about the direction of inflation. The survey tells us consumers believe inflation will fall in September to 4.4%. We will wait to see how accurate this survey is. In the same survey 9.8% of the respondents thought the inflation rate would fall to below 3%, the RBA’s target level.

Let us suppose the great consumer has successfully predicted the inflation rate for the September quarter. The survey recorded 5.9% for July, 4.9% for August, and 4.4% for September. Yielding an average of 5%. This is still significantly above the RBA target band of 2-3%.

The ABS is due to release the September quarter CPI on 28th October. So, how did the Melbourne Institute survey perform in the previous quarter? The results were as follows. April 4.3%, May 5.2% and June 5.9% for an average of 5%. This was above the official figure for the June quarter of 4.5%.

We can’t extrapolate any further than to say that consumers overestimated inflation on average during the June quarter. It is possible they will do the same this quarter. The unknown quantity is what impact reporting of inflation expectations in the media has on the respondents.

Cost of Living Remains High
At the time when consumers were predicting inflation of 5.9% the media was full of stories about high petrol and food costs. Since then the price of petrol has moderated. Yet is still remains around $1.50 per litre, which is not that significantly lower than four months ago.

Because of this moderate decline in petrol costs there has been little comment in the press about it and therefore minimal commentary on the still high costs of living. Therefore, there is the reasonable prospect that consumers are being lulled into a false sense of low inflation and could be in for a shock when they realize their money isn’t worth quite as much as they thought.

We shouldn’t forget the unemployment numbers either. The RBA reduced interest rates this month because it believed that the economy was slowing. However, it did not want the economy slowing too much for fear of triggering a recession.

Although the RBA only made the decision this month, it had made it clear well in advance that an interest rate cut was on the cards. It is possible that Australian industry has pre-empted the RBA, anticipating the cut and hiring staff. The effect of this is to keep the labour market tight and potentially drive up wages and prices. Exactly the opposite of what the RBA is supposed to be striving for.

Boom and Bust
It could be argued the RBA’s intentions are admirable in trying to avert boom and bust cycles. The problem it now creates for itself is a continuous cycle of industry, the consumer and the RBA all trying to pre-empt each other’s actions.

The first secret to trading currencies is pretty simple: Follow the fundamentals.

How do you do that? First of all, pay attention to what central bankers are saying about their economies. This is important. They may not always give you all the facts, but you can usually get at least an idea of what they will do next from their statements.

Central bankers will give you their thoughts on their respective economies. And if they don’t tell you outright, you can tell by their actions. For example, when central bankers raise rates, it means they’re fighting inflation. That’s usually a good sign for the country’s currency. However, if inflation is shrinking or if the central bank is in “rate cut” mode, then it’s bad for the currency.

If the economy is growing (according to its GDP numbers), then that’s another plus for a country and its currency. On the other hand, a falling GDP either means a country is slowing or the economy is shrinking rather than expanding. Either way, that’s a bad thing for the currency.

So to find the perfect currency pair to trade, you need to play “matchmaker.” Match up the best-looking country with high inflation and rising interest rates to the ugliest country with the worst fundamentals (lower inflation and slashed interest rates). Once you have your “best-of” and “worst-of” currencies, simply trade the good country vs. the bad country.

For example, let’s say you decided the U.S. dollar was the “ugliest” currency in the world because the U.S. is slowing and the Fed just cut rates. You also decided that the euro was the best-looking currency. In this instance, you would buy the EUR/USD pair.

In that context we were discussing the misfortunes of the Australian dollar during the last two months. But the same can be said for the stock market as well. During the current earnings season there has been a bit of a mixed bag with some showing excellent revenue and profits (BHP and Rio) while others have been woeful (Babcock & Brown).

At the moment, the outlook for a broad rise in the stockmarket doesn’t look good. Ever since the market topped out last October the S&P/ASX200 has continued to drift downwards, punctuated by false rallies on the back of over optimism.

But there is light at the end of the tunnel. The problem is that we can’t quite work out how long the tunnel is. There are positives that should ensure that Australia emerges from any economic downturn without too much agony.

As a resources led economy there is often talk that any downturn in the US economy will reduce demand for goods there, which will reduce demand for imports to the US from China which will reduce demand from China for Australia’s resources. Of course, this will have an impact but probably not to the degree that is feared.

Thanks to the massive demand for raw materials companies such as BHP Billiton, Rio Tinto and Fortescue Metals have been able to charge big premiums for their commodities. Any downturn in the US and Europe is bound to have some impact, however there is still ample room for Asian economies to grow without the need to rely on the US and Europe. Demand for Asian domestic consumption will be the next growth area as incomes rise and the standard of living rises with it.

Another insulator for Australia is the concentration of business in a small number of large companies. Many Australian sectors are in effect presided over by duopolies where the lack of major competition has allowed them to maintain healthy profit margins. The relevant smallness of the Australian economy makes it that much harder for new entrants on a large scale.

This allows them to maintain some of their margins without the fear of being undercut by competitors. And when competitors do come into the market they have to work fast in order to build up market share. A tough ask when consumers are comfortable the same brand they have used for years.

So what does that mean as investors? It really means that with the market having fallen so far since last year, the opportunities for value in this market are starting to present themselves so now is the time that investors should be starting to get back into the markets. Unfortunately, history tells us that for most retail investors they tend to exit the market just at the time when they should be getting back in.

In my opinion, there is one thing that separates the novices from the professionals in the Forex market: Novices gamble and professionals trade.

This is a key distinction because it’s the reason countless new currency investors have trouble trading in the Forex market.

So what separates gambling from trading? In a word: Risk.

Successful traders take calculated risks. They gauge the risks to each trade and allocate their funds accordingly. In other words, they think about what they could lose on a trade - rather than just the possible gains.

To be successful, you need to think about how much you’re betting on each trade. Take this into account when you’re placing each order. Make sure no one trade can wipe out your account.

This is how the professionals trade. And even though you aren’t trading billions, you can still profit from the same strategy.

The dollar has gained against global currencies since August 8, when Germany’s mighty economy contracted in the second quarter, triggering one of the biggest dollar rallies in years.

And maybe it was time for a rally. Since peaking more than six years ago versus the world’s major currencies, the U.S. dollar has posted some dizzying declines. Only a few currencies in the world have actually declined in value against the sad buck since late 2001…one of which being the Zimbabwe dollar.

But this current bout of dollar strength has more to do with the surprising weakness of other foreign economies than a resumption of U.S. growth. We’re simply ahead of the curve.

The market views the dollar as a leading currency as other economies begin to grapple with an economic slowdown or, in some cases, recession. The United States has already gone through the process of priming the economy with interest rate cuts and fiscal measures to boost consumption, driving the dollar lower in the process. Now it’s the turn of the Europeans and Japanese. They are only now starting to enter slowdowns in their economic cycles.

That means they’ll be cutting rates, so their currencies will weaken. And the value of their assets – in dollar terms – will decline.

Therefore, savvy investors in the next few months will look to build positions in some of the U.S. economy’s most beaten-down, oversold assets. Specifically, foreign and U.S. investors alike can find significant value and opportunity in distressed U.S. debt, real estate and stocks.

This is pretty typical of professional traders. All the pros leave the FX market alone on holidays. In fact, my opinion is that the Forex market should post a sign that says “Enter at your own risk” during major U.S. holidays.

I say this because the Forex market is like a renegade switch on most holidays. The market is either “turned on” and your trades are moving like crazy (which means it’s hard to predict what will happen next). Or the market is completely “turned off,” and it’s about as interesting as watching paint dry.

More often than not, you’ll see BOTH scenarios happen on a single holiday. First the market will be switched on, and then it will suddenly switch off - or vice versa. Unfortunately, there’s never any telling which comes first…the “calm” or the “storm.”

So on any given holiday, I generally wait until the afternoon to check on the currency markets. Then I just wait for the “show” to start. Frankly, for a seasoned trader like myself, it’s fun to watch the markets move that fast.

But it’s definitely NOT time to start trading. Please keep that in mind for every holiday going forward.