Click to enlarge

A quick look at the weekly chart of the Aussie shows it is in a very strong uptrend at the moment. The market took five years to rally from 60c to 94c between 2003 and 2008. We’ve rallied that far in a year and a half.

That’s truly amazing stuff.

With the momentum so strong to the upside it would be a brave man or woman to stand in the way of this steam train and I would need to see some clear signs of failure before I would start getting bearish on the Aussie dollar.

Also we’re now getting very close to the 2008 high of 98.5 cents and the market is so focused on reaching parity that I wouldn’t be surprised to see some ‘blow off’ rally attempting to take out the 2008 highs and aiming for parity.

The music could then easily stop and we could see a false break of the 2008 high which could then be a great shorting opportunity.

If we get up close and personal with a daily chart of the AUD we can see a sideways distribution forming:

Whatever the result of the upcoming consumer price index (CPI), homeowners should be prepared for an official interest rate rise on Melbourne Cup day.

The latest readings of CPI and underlying inflation at 1130 AEDT will determine the likely pace and size of interest rate increases by the Reserve Bank of Australia (RBA) over coming months, economists say.

The RBA holds its next monthly board meeting on November 3.

“Even if (CPI) comes in on the low side they are still going to do 25 basis points next week,” Nomura Australian chief economist Stephen Roberts told AAP.

The RBA has made it clear that it feels that it would be “imprudent” to keep the official cash rate at “emergency” low levels when the economy is in recovery.

It raised the cash rate to 3.25 per cent from 3.0 per cent early this month, and a further 25 basis point increase would add another $45 to monthly repayments on an average $300,000 mortgage.

Economists’ forecasts centre on an annual CPI rate of just 1.2 per cent as of the September quarter, remaining below the RBA’s two to three per cent inflation target.

However, annual underlying inflation is expected to remain stubbornly high at 3.45 per cent.

Rate swaps slip

Australian rate swaps fell and bond futures rose on Tuesday, as markets pared back expectations for a 50 basis point interest rate increase next month and as caution prevailed ahead of price index data.

Australian three-year futures rose 0.06 points to 94.61 while the 10-year contract was 0.025 points up at 94.275.

Interest rate swaps also fell on comments from influential columnist and central bank watcher Terry McCrann which were taken by the market to mean the Reserve Bank of Australia was unlikely to make an aggressive rate increase.

“The writer now sees a 50 basis points (bps) hike as less likely, really not a surprise given the lower PPI reading and the wobbles that are appearing in equity markets,” said Sean Keane, director of Triple T Consulting and former money market trader at Credit Suisse.

The 5-year interest rate swaps fell by two bps to 6.05 per cent.

Implied cash rates, based on money market and swap rates , are fully pricing in a 25 basis point hike and factoring in around a 25 per cent chance the central bank will raise rates by 50 basis points on November 3.

That compares with a 30 per cent chance of a half percentage point increase factored in last week.

“People are squaring up ahead of tomorrow’s consumer price index data and equity markets were not impressive today and that probably helped bonds and fixed income products,” said JPMorgan rate strategist Sally Auld.

Slow superannuation recovery

While households consider the implications of rising interest rates on their major asset, their second biggest investment - superannuation - is showing a slow recovery after the shock of the global financial crisis.

A report by the Organisation for Economic Co-operation and Development (OECD) shows that Australian super funds recovered 1.0 per cent in the first six months of 2009 after a drop of over 20 per cent in 2008.

This compares with an average 3.5 per cent recovery among pension funds across OECD countries and returns of 10 per cent in Norway and Turkey.

“The impact of the crisis on investment returns has been greatest among pension funds in the countries where equities represent over a third of total assets invested,” it said.

“In 2008, Australian pension funds were the most exposed to equities at 59 per cent of total assets.”

The Paris-based institution said funds in other countries benefited from having a large proportion of their assets invested in bonds, whose rates of return tend to be lower but more stable than those in equities.

Still, an analysis by Commonwealth Securities chief economist Craig James shows that the value of the Australian share market has now risen by over $500 billion to $1.4 trillion since March.

“It has been a great rebound, but it was a humongous drop from the highs of late 2007 and we still have some work to do to prepare the damage to superannuation and to wealth levels,” Mr James told AAP.

“But certainly from all the developed share markets and economies, you would have thought Australia was in the best position to claw its way back to those highs (of late 2007),” he said.

The S&P/ASX 200 share index closed at 4,753.5 on Tuesday compared with around 6,800 in late 2007.

Australia is the biggest the beneficiary of China’s industrialisation and has a strong banking and corporate sector.

Mr James defended super funds’ investment weighted towards shares.

“Over a long period of time domestic shares have outperformed other asset prices by a very significant magnitude,” he said.

“You could take short-term strategy and opt for safe haven bonds or cash, but really that’s not the strategy we advise for individual investors and it shouldn’t be what super funds take on either for the broader masses.”

It looks like the market down under will begin pricing-in the shift in policy stance by the Reserve Bank of Australia. Over the weekend The Sunday Telegraph revealed that the Big Four banks within the country will be hiking rates faster than that at which the RBA is raising them. That is, mortgage, credit card rates, etc will begin to rise as the central bank raises the costs of funds that the bank borrows. This could be very beneficial for the Australian Dollar. Not only will the overnight lending rate rise, but so will longer term 30-year mortgage ones. Global investors who are looking for attractive yield might shift more of their focus toward the country as a result. Let’s not forget that as market rates rise, the government has to also take measures to attract investors toward their debt. Since all of these assets are priced in Australian Dollars, the currency will naturally rise in value versus that of low-yielding countries.

Why Stocks May Not Move
Higher Following Earnings Season

Everywhere we look there seems to be a property connection, even the US GDP numbers are said to have been negatively influenced by slowing investment in US residential property.

This morning we’ve been feverishly finishing off the August edition of Australian Small Cap Investigator. In fact, if you’re a subscriber, there’s a chance you’ll get it even before this newsletter gets to you.

In some ways, the current market conditions make it harder to pick stocks than when the market was hitting lows in November last year and then in March.

Even though we didn’t know for a fact that it was a low point, picking stocks was a lot easier. Especially small caps.

When you’re investing in a market as high risk and volatile as the exchange’s little tiddlers, the extra volatility suffered by the rest of the market was nothing new. It’s what we’re used to at this end of the market.

That means, when you’ve got small cap stocks getting beaten down to bargain basement prices, you know they can’t go much further - or you hope they can’t anyway.

Then it’s just a case of picking out the good ones. Of course, it’s not quite as simple as that, you’ve still got to know what to look for.

As you know, the market is always looking ahead. Back then it was looking ahead and seeing the worst. When that’s priced into a stock it makes the stock even cheaper than it should be.

Now, the market is looking ahead and it’s seeing nothing but happiness.

It’s why the main index is up over 30% from the low. So now, when you’re picking stocks you’ve got to work out rather the move is justified and whether there is still room to move higher.

That’s the case with all stocks, not just the small caps. You can see by looking at the chart below that after the big run from July, the market appears to be settling into another consolidation phase:

It would be easy to think the move from early March to today has been smooth. But another look at the chart tells a different story. In fact between the beginning of April and the beginning of July the market just about broke even. Then it took off again.

But that’s all part of the game. There’s nothing particularly scientific about it. It purely means that between April and July investors as a whole considered the rally to have run its course, and perhaps there was some caution as earnings season approached.

As can happen, when company earnings started coming out better than expected it gave the market a reason to buy stocks again. That’s pushed the market higher.

Now earnings season is mostly over, the market will need to look for other reasons to move higher. If none are found that’s when you’ll see a sideways consolidation.

Still, the market has put on about 200 points since it dipped last week. And this morning it’s edging higher again.

But whatever happens, trying to make specific long term predictions about a level for the major indices is doomed to end in embarrassment for those that try. So we won’t be tempted.

The S&P/ASX200 fell 0.08% yesterday, while on Wall Street the Dow Jones Industrial Average added 37 points. In Europe the FTSE100 slipped 0.43% and the CAC40 dropped 0.54%.

The price of gold in Australian dollars is trading at $1,133.24, while in US Dollars it is trading at $950.79.

The Aussie dollar strengthened slightly versus the US dollar and Japanese Yen, trading at USD$0.8394, and JPY78.57.

Crude oil traded this morning at USD$72.74

The first currency offers some of the most compelling long-term buying opportunities in the world right now with healthy balance sheets, wealthy benefactors, and a positive long-term growth story.

The second…well, let’s just say it’s a great shorting opportunity if nothing else.

In fact, the only thing these two currencies have in common is they’re both considered commodity plays.

Let’s start with the buying opportunity. To go there, let’s head to the land of Samba and Feijoada first. Yes we are in Brazil.

The Australian dollar has leapt 15% since the beginning of the year (indeed, that’s one reason why the Aussie is my favorite currency over the next six months). But while the Aussie has climbed 15%, the Brazilian real has shot up 22.5% year to date. It is running hotter than all currencies against the U.S. dollar.

You can attribute a lot of this to the world’s insatiable demand for Brazilian commodities – especially the ones China and India are gobbling up. China’s influence in Brazil has reached such an extent that you could be buying a Brazilian stock as a China play these days.

In fact, a Chinese company recently granted a $10 Billion loan to Petrobas (Brazil’s largest oil company) in exchange for first rights to the oil that Brazil will drill at its newfound reserves.

The Australian theme, (China buying up the world’s commodity reserves strategically) is alive and kicking in Brazil too. As I have said before, as China continues its strategic grab for world power, Brazil will remain relevant in the global economy.

There are traditional range opportunities in some of the majors (like EURUSD and GBP for example); but the lack of profit potential and the terminal patterns these pairs are developing suggest breakouts are a real risk. Instead, I am looking for the relatively quiet conditions for the broader market to temper AUDCAD’s aggressive momentum.

Trading Tip – There are traditional range opportunities in some of the majors (like EURUSD and GBP for example); but the lack of profit potential and the terminal patterns these pairs are developing suggest breakouts are a real risk. Instead, I am looking for the relatively quiet conditions for the broader market to temper AUDCAD’s aggressive momentum. This pair is still mired in a steep, bearish pitch; but the drive behind this move is circumspect and obvious technical levels are offering reason for a stall and reversal. This is certainly a much more speculative proposal than usual; so I will need to approach with caution. Our strategy has entry that is now above spot; which in effect requires something of a reversal to trigger entry. Furthermore, the stop is set wide enough to cover the zone of support along with the general rising trend with a buffer for false breakouts. The initial objective is set within an average daily range; but the second target looks to recoup risk and capture profit on a large rebound. Since this position is already setting up, we will cancel any open orders in 24 hours.

Event Risk for Australia and Canada

Australian – The Australian dollar is first and foremost tied to its sentiment. Relatively strong growth, a high benchmark lending rate and heavy exposure to commodities makes this a speculative favorite. For general risk appetite, no gauge is better to reflect investor optimism than equities. Though the market is more congestive than trending; the general bias has clearly taken a disappointing shift. For specific event risk, the Aussie docket doesn’t really threaten price volatility until next week. The NAB business confidence figures are noteworthy; but they have shown little in the way of market movement in the past. Along similar lines the Westpac Leading Index is too lagging and inaccurate to benchmark a 2Q GDP number that is a long ways off. After the weekend, 2Q inflation and RBA minutes however will give us direct insight into interest rate forecasts.
   
Canada – Canada is the fundamental black sheep of the majors. The economy has avoided the worst of the economic recession with relatively strong domestic demand and healthy exports. What’s more, the local impact of the global financial crisis has been surprisingly limited. However, unlike its Australian counterpart, the Canadian economy has fallen into recession. With clear ties to the health of the US, there is a clear anchor on the performance of the world’s eighth largest economy. This is the reason for the dour forecasts from policy officials; but the favorable comparisons to the nation’s largest trade partner keeps speculation on an even keel. However, these are long-term considerations. Through the short-term, shifts in market sentiment will likely be responsible for most swells in volatility outside of general market tides. From scheduled event risk, there is notable data ahead; but its cumulative market moving impact is doubtful. This week sees manufacturing shipments for May and CPI for June. The former lags the physical trade report and the later is a practice in policy-based economics. The top release is next week’s BoC; but even that is not expected to develop any surprises.

During early deals on Monday, the Australian and New Zealand dollars plummeted against their key counterparts as Asian markets extended their slide on concerns over the U.S. economy and corporate earnings.

Renewed anxiety about the pace of recovery in the world economy has kept stocks from rallying further after huge gains between March and June.

Investors are now looking to second-quarter corporate earnings and profit outlooks for the year, to be issued in the coming weeks, for guidance about the economy’s prospects.

In Australia, the S&P/ASX 200 index .AXJO fell 56.6 points to close at 3,737.5. New Zealand’s benchmark NZX 50 index .NZ50 was little changed, edging down just 1.4 points to 2,736.9.

The Australian and New Zealand dollars also declined as oil prices dived in Asian trade, with benchmark crude for August delivery down 71 cents to $59.18 a barrel. The contract fell 52 cents to settle at $59.89.

Oil prices dropped 11 percent last week in their biggest weekly decline since late January amid mounting worries that a economic rebound may not be coming soon to help spur flagging fuel demand.

The Aussie jumped to 0.7826 against the US currency and 72.73 against the Japanese yen at 8:55 pm ET Sunday. Thereafter, the aussie weakened and touched a 7-week low of 0.7714 against the greenback and a 5-day low of 71.03 against the yen by about 2:45 am ET Monday. If the Aussie slides further, it may likely target 0.747 against the greenback and 70.6 against the yen. The aussie-greenback and the aussie-yen pairs were worth 0.7789 and 72.03, respectively at Friday’s close.

In economic news, a report by the Australian Bureau of Statistics said housing finance for owner occupation, which excludes alterations and additions, climbed a seasonally adjusted 2.3% month-on-month in May. Owner occupied housing commitments increased to A$17.04 billion from A$16.6 billion in the preceding month.

At the same time, personal finance dropped 2.9% to A$6.03 billion and lease finance fell 1.9% to A$412 million. However, commercial finance rose 4% to A$28.3 billion, all in seasonally adjusted terms.

The Aussie slipped against the euro after reaching a high of 1.7868 at 8:55 pm ET Sunday. At 2:50 am ET Monday, the aussie fell to a 2-month low of 1.8042 per euro and this may be compared to Friday’s closing value of 1.7919. On the downside, 1.815 is seen as the next target level for the Australian dollar.

At 2:50 am ET Monday, the Aussie plunged to a new multi-week low of 0.9020 against the Canadian dollar, compared to an early Asian session high of 0.9083. The next downside target level for the Australian currency is seen at 0.893. At last week’s close, the aussie-loonie pair was quoted at 0.9066.

Risk trends are starting to pick up; but without a clear cut fundamental driver or even direction through market sentiment, the activity threatens range boundaries with the potential for false breakouts. AUDNZD is naturally sheltered from much of the spurious shifts in sentiment that happen from day to day; but the economic and financial disparity between the two retain a link to this most common of economic drivers.

Trading Tip – Risk trends are starting to pick up; but without a clear cut fundamental driver or even direction through market sentiment, the activity threatens range boundaries with the potential for false breakouts. AUDNZD is naturally sheltered from much of the spurious shifts in sentiment that happen from day to day; but the economic and financial disparity between the two retain a link to this most common of economic drivers. It is further comforting however that scheduled event risk is relatively light and spread out (a nest of indicators released with similar surprises have a greater chance at forcing a breakout). However, the most promising aspect of a range-based setup for this commodity cross is the state of technicals. Long-term trends are at stake with recent price action. Just like the third attempt to run 1.30 and on to new nine year highs failed back in May, we are now coming on support that defines this pair’s general bias going back to October (or 2005 depending on what you consider to be a clear trend). Our strategy works with the bias and is further backed by a clear confluence of support. The stop is set wide enough to avoid most false breakouts while keeping with the general trend and both targets are within the range of two days. We will cancel all open orders before liquidity drains for the weekend.

Event Risk for Australia and New Zealand

Australia – In comparison to its counterparts among the majors, the Australian dollar holds the best fundamental prospects. It was no small feat that the economy was able to avoid a contraction in first quarter growth and thereby put off the title of recession. Going beyond the label of economic stagnation, Australia has enjoyed strong domestic trends and maintained its vital exports to help avert a localized financial crisis and dramatic reduction in credit. The benefit of these promising conditions is a relatively high benchmark lending rate (held at 3.00 percent) that trickles down into returns through national assets. This puts the Australian economy at the forefront of a potential global recovery – but therein lies the dependency on the broader world for performance. This is why the Aussie dollar will not be able to fully detach from trends in risk appetite. As for event risk, the docket is relatively light for the coming week. The NAB business confidence number for June is the only figure with true economic implications; yet it has little precedence for impact.

New Zealand – New Zealand is everything that Australian exemplifies minus most of the latter’s positive attributes. A heavy dependency on exports finds its demand from Asian trade partners. More poignantly, New Zealand’s economy is heavily linked to its bigger brother, Australia. However, from there, domestic activity is depressed and highly volatility. The island nation is struggling with financial markets and is seeing capital flows drying up due to investors’ caution and a tumbling interest rate. On the other hand, when optimism surrounding global financial and growth trends improves, New Zealand is positioned to reap the greatest benefit. Looking at economic data due, retail sales, business sentiment and consumer-based inflation makes for a market moving concentration.

Australian Dollar Falls To 13-day Low Against US Currency

The Australian dollar edged down against the US currency during early deals on Monday. At 3:10 am ET, the aussie-dollar pair declined to a 13-day low of 0.7899, compared to 0.7977 hit late New York Friday. If the pair falls further, 0.785 is seen as the next target level

Still positively correlated with the stock indices, particularly the S&P/ASX 200, the AUD/JPY currency pair strongly rebounded between February and June this year. It posted a recent high on June 11 at 80.43 (point C on the chart). From the low of 55.51 posted in early February (point E), it’s a rise of 45% in 4 months and a half.

The trends are therefore really easy to identify on this chart. First, there was a sharp bearish trend that drove the price from 104.50 to 55 in the second half of 2008 (between points A and B), when the financial crisis was spreading globally. As you know, this plunge particularly impacted the commodities and stock markets, but also the FX carry trades. The AUD/JPY was one of the most popular carry trades: risk aversion and deleveraging hit strongly the value of the “Aussie” against the Yen.

Click to enlarge

The bullish trend that followed (between points E and C) retraced half of the previous plunge. Indeed, the price action failed on the 50% Fibonacci retracement level, which corresponds to the level of 80. This level acts as a resistance line and is likely to hold firmly. The price peaked on this level three weeks ago, and immediately corrected. This was due to profit-taking and short-selling around this key Fibonacci ratio. As a result, the price fell back to the previous Fibonacci level (the 38.2% ratio, point D) where it found some support. Then the AUD/JPY has been bouncing back for one week now. A new attempt to break above the resistance line is probable.

Look at the Bollinger bands: the price action found bounced on the lower band. A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets. The upper band currently corresponds to the resistance line at 80. This is the objective for the current price action (the AUD/JPY is currently trading around 77.70).

But as mentioned above, the resistance is likely to hold. The indicators show that a bearish divergence has appeared. The MACD did not confirm the new high of the price action in June, and has already started curving downward. In this scenario, the AUD/JPY should quickly jump to 80 and then correcting strongly in the following weeks.

Before you get too excited, I’m not about to reveal a way of getting back money you’ve lost in investments, or money that’s dropped out of your pocket, or that’s been lost down the back of the sofa.

Rather, I’ll try and put paid to a theory that is already resulting in higher interest rates, and will soon reveal the consequences of higher inflation.

You may have seen the argument in the press or on TV. It goes that because asset prices have fallen so much during the last eighteen months, there is less ‘money’ in global economies and therefore any stimulus from the government is filling the gap vacated by the consumer and business.

But it’s not the only argument used by mainstream economists and commentators to argue that fears of inflation are over-blown. They also tell us about Japan, where the government set interest rates to zero and gave trillions of Yen to the banks in an attempt to stimulate their economy.

This didn’t work and Japan had its ‘lost decade’ where there was very little inflation and very little asset price growth.

While we won’t claim Japan is perfect - it clearly isn’t with the amount of debt it issued - it should be remembered the Japanese central bank issued new money in a different type of economy.

It was issued to a saving economy rather than a spending economy. It’s one of the reasons why Japan holds so much US debt. Rather than the additional Yen being spent it was simply used to take advantage of the carry trade.

The borrowed Yen was sold, converted into US dollars and held in US treasury bonds. This naturally had a weakening effect on the Yen, keeping it low and therefore keeping its exports strong.

It isn’t a particularly good idea, and because of it, Japan shouldn’t be viewed as a leading light of free markets. They’ve manipulated their own economy just as much as the US has. That means there’s just as much change the Japanese economy will suffer for it as well.

In fact, the mistake mainstream economists and commentators make is to think Japan won’t suffer from future inflationary pressures. They assume the story is over - that Japan printed lots of money, it didn’t cause inflation and therefore other central banks can do the same thing.

But they forget a couple of things. The first is that Japan has a higher savings rate. That means there is a demand for investments rather than spending. Therefore the debt was easily ’soaked up’ by the market as there was ample demand.

That’s why Japan has been able to keep its interest rates low. It hasn’t had to increase them in order to attract savers. They have willing savers.

The other side is that Western nations, mainly US, UK, Australia and Western Europe have lower savings rates and are more inclined to spend. And what did they spend their money on? Imported goods from Asia.

As we have seen, it is already causing interest rates to rise, as central banks have to offer more attractive rates as the amount of debt increases.

Therefore it is foolish to use the experience of Japan to argue that it is good to pump more money into the economy to stimulate it.

At some point the Japanese economy will also suffer from excessive inflation. That it hasn’t done so yet doesn’t mean it won’t. The high savings level just means the spending is pent up, waiting to be released.

And it will either be released in the form of direct consumer spending or the private sector borrowing to invest in capital or goods. Either way it will filter through to increase the cost of living for the Japanese citizen.

Perhaps it already has. Odds are that Japan’s deflation would have been greater if it wasn’t for their stimulus.

But it isn’t just the Japanese that are being used to make excuses for increased spending and printing money. We came across this gem of a graph on the internet…

It illustrates how the “money printing” by the US Federal Reserve is tiny when compared to the fall in household asset values. It’s like a “drop in a bucket” in comparison.

We’ve seen a similar argument used by analysts on the business channels over recent months. They claim that because so much value has been lost on financial markets, any stimulatory spending by governments or money printing by central banks could not possibly be inflationary as it is only replacing a fraction of the money that has been lost from investments.

This reasoning is flawed. But let’s take a closer look at what they mean.

What they’re trying to say is because share prices of say, Citigroup, General Motors, Bank of America and Lehman Brothers have fallen so much, billions and trillions of dollars has been wiped off the ‘balance sheet’ of individuals.

So, because their investments have declined by so much it means if they cashed in on these investments they would get back much less money and therefore have much less to spend.

Therefore, if governments decide to give these people a handout or spend the money on infrastructure it cannot be inflationary.

Have you spotted the flaw? If you have, you’ve done better than most of the boffins that would have you believe that inflation is not a concern.

They mistakenly equate an investment with money. It isn’t. When the share price of Macquarie Group fell from $99 to $20, it may have wiped several billions of dollars off the ‘value’ of Macquarie shares, but it did not alter one cent the amount of dollars in the economy.

And that’s where these boffins are making the error when they argue that new government spending won’t have an inflationary impact. It will.

It’s quite simple. If we take a share trade as an example, when you buy shares you are exchanging your cash for ownership of shares. From that point you no longer have cash. The investor you bought the shares from holds the cash.

That means, if say, the shares went to zero there hasn’t been any loss of money from the system. It is still there, only it is the person who sold the shares to you that is holding it rather than you.

It is even the same if leverage is involved. It makes no difference. The money is still there, only it is being held by someone else other than the shareholder.

Look, that may be stating the obvious, but it’s amazing how many excuses and ‘reasons’ the mainstream commentators are coming up with to deny the threat of inflation.

But it’s not only the commentators. Policymakers have been acting in precisely the opposite way to how they should. Instead of trying to prop up the value of assets or investments, it is the value of cash/money that needs to be increased.

And that should be done through higher interest rates and/or decreasing the money supply.

You see, the current global bout of low interest rate policies is actually discouraging real investment. Instead it is encouraging speculation.

The correct course of action would have been to keep interest rates at previous levels or in fact increase them. (Naturally, our preference would be for interest rates to be left to the market, and for no interference at all by central banks, but that’s a bit too much to hope for at the moment).

Keeping interest rates higher would have encouraged more savings and therefore it would have brought interest rates down without central bank manipulation. Once interest rates had fallen, entrepreneurs and businesses would be prepared to borrow funds to invest in their businesses.

This action - if the businesses are publicly listed - would have led to companies becoming more valuable as it invests productively in its business, and therefore lead to an increase in share prices.

The way policymakers are trying to run the economy is by getting assets prices high and hoping that will lead to an increase in wealth and spending. It may very do that, but with an added consequence of higher inflation as more money is fed into the economy from misdirected government spending.

Other Stuff on the Markets

The S&P/ASX200 added 15 points on Friday to close at 4,062.2. There was a mixed night on Wall Street with only the Dow Jones Industrial Average gaining. It closed 28 points higher.

Meanwhile, in Europe the FTSE100 dropped by 0.45%.

The price of gold in Australian dollars has eased to $1,157.00, while in US Dollars it lost ground to USD$935.90.

The Aussie dollar remains steady, trading this morning at USD$0.8074 and JPY79.55.

Crude oil finished trading for the week at USD$72.16.

So straight to the chart:

click to enlarge

If you are an exporter you may like the direction of the Aussie – down, down, down. If you are an importer or are wanting to buy a consumer durable then you won’t like it. Consumer durable? Give us plain speak Tom. Ok. Durables are things that last. Well that was how it was when the term was first used. Things like cars, TVs, fridges etc. But we know they don’t last like they used to – like ‘in the good old days’. There is a sort of ‘planned obsolescence’ and therein lies a problem. Planned obsolescence was working until the recession hit – yes it is here – and we stopped buying. And if we haven’t stopped yet we will soon – especially ‘durables’ because they are going to be heaps more expensive.

We stop buying ‘durables’ and ‘consumables’ and China and others slow down imports of raw material, demand for the Aussie dollar falls – which could again become the ‘lil Aussie battler’ – and demand for our currency will fall. London to a brick.

But you may ask is the savage fall of the Aussie – just that – or is it the rise and rise of the American dollar? There is no definitive answer to that. It is a bit of both but which is the more dominant cause I could not put hand on heart and state categorically. I am sure there is some Rhodes economic scholar that has the answer. But not Tom.

For many holders of USA debt a fall in the US dollar would be very nasty indeed. I am not suggesting that they are holding the US dollar up but pain will set in if it falls.

So that is why I say it is all a tangled complex web.

And I am going to add one more ponderable. The above daily chart showed a continuing downward path for the Aussie but if we look at a weekly chart we can see a slightly varying scenario:

click to enlarge

And that is the prospect of a relief rally before the final fall from grace.

If I was to show a chart for say copper – of which we export heaps – it would be almost the exact same for the above. That is we may see an easing in the US dollar, a rise in US denominated priced copper and other base metal prices and a rise in the Aussie for a while.

Sometimes it is really clear and other times it is ‘clear as mud’

First of all, it’s important to note that gold is one of Australia’s biggest exports. There are often huge correlations between the Aussie dollar (AUD) and gold. However, there are periods of disconnect there as well.

Let’s take a look at the chart below that goes back about four years.

Sometimes Commodities “Disconnect” from Their Currencies

If gold and the Aussie dollar always correlate, then the AUD/USD and gold should always head in the SAME direction. They often do. However, there are exceptions. I drew yellow arrows on the graph above to show you the exceptions to this rule.

For instance, in 2005 the Aussie dollar actually traded OPPOSITE of gold’s price. This means the U.S. dollar and gold both rallied at the same time, in the same direction. While that doesn’t happen often, it does happen.

Also, I’d like to point out how gold and the Aussie dollar have acted this year - particularly from about July up until now. Notice that most of the time, the AUD/USD and gold have similar “magnitudes.” In other words, they both rose and fell at a great degree.

In recent months, gold had a decent fall… but the AUD/USD just got absolutely unduly punished.

In fact, the AUD/USD pair has fallen about twice as much as gold has. So this shows that not only can their directions move differently (like in 2005) but also the magnitudes of these two can vary as well.

Correlations hold true generally, but there are times when they buck the norm. You want to be prepared for those times when they come. Don’t make the mistake of assuming that these com-dollars always dutifully track commodity prices.

The recent fall in the value of the Australian Dollar, while painful for Australians looking to travel overseas, has proven popular with many traders whose trading accounts are denominated in US Dollars.

From a traveller’s perspective, every cent that the Australian Dollar falls means less spending money in their pockets when they convert their Australian Dollars into US Dollars.

However, the sharp falls have eased the pain of those traders watching their US Dollar accounts erode in value with the strengthening Australian Dollar.

Imagine you were a trader who wanted to trade options on the US market. You open an account with a US Broker in 2002 and send over $A10,000 to fund your account. With an exchange rate of 0.5000, you now have $US5,000 in your account.

Now imagine you are a conservative trader and over those 6 years you managed to double your trading account. Your trading account is now $US10,000.

Now you decide to bring the money back to Australia. However, it’s 2008, and the exchange rate is now 0.9800 (98 cents). Suddenly, you need 98 US cents just to buy 1 Australian Dollar, whereas six years ago, you only needed 50 US cents.

Now your $US10,000 – which was double your initial investment - is only worth $A10,204. Nearly all of your gains have been wiped out by the exchange rate fluctuations. Can you see the importance of managing your currency risk?

Chart 1 below shows the weekly bar chart of the Australian Dollar (FXADUS in ProfitSource)

Chart 1

click to enlarge

As you can see, it is not just Currency Traders who are faced with the risks associated with changes in the exchange rate. Of course, had the trader waited until October to bring their US Dollars back to Australia, the exchange rate would have been much more favourable for them.

Anyone with any exposure to overseas currencies, whether through their trading, their travel plans, or business transactions needs to manage their currency risk.

So how can we go about it?

The simplest way to lock in the exchange rate today is to open an FX trading account. Let’s say we have some US Dollars sitting in a bank account in the United States.

If the Australian Dollar rises in value, the US Dollars will fall in value, meaning less Australian Dollars should we decide to bring the money to Australia. To lock in the current exchange rate, we can open an FX hedge by opening a currency position.

In any FX transaction, we are always buying one currency, and selling a second currency.

So in this case we would open a position that would buy Australian Dollars, and sell enough US Dollars to cover the money in our US bank account.

As long as there is enough money in your FX trading account to cover the margin on the trade, you will be able to leave this hedge open until you are ready to bring your US Dollars back to Australia. If Australian interest rates are higher than US interest rates, you can even be paid interest on your position, in what is called a “carry trade”.

If you have US Dollar exposure and you don’t check the exchange rates very often, it can be a good idea to hedge your position and lock in your exchange rate, to remove the possibilities of any nasty surprises.

There are other methods for locking in an exchange rate using Forward Exchange Contracts and options, however that is a subject for another article.

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.

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.