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.

So as traders all around the globe watch their bottom lines bottom out and their hedge funds blow-up, I’m flat-out loving this market.

Why? I have a secret weapon that lets me profit when markets are sinking, while my stock trading buddies can barely stay afloat with their stocks.

What’s that secret weapon? The Japanese yen. You see, when volatility increases in the markets and stock traders lose their shirts, their loss is my gain. The Japanese yen experiences an uptrend when almost every other asset class (even commodities) is headed downhill.

At times like these, I can pair the yen with almost any currency in the foreign-exchange market and I’ll win. I know the yen thrives off of volatility, so one of my buddies’ strongest tools works even better for me during bear markets.

Stock traders all over the country look to the VIX (Volatility Index) to gauge when the stock market may bottom. They wait until the VIX rises to an extreme level and then they go in and buy. However, I watch the VIX heading higher and I know it’s giving my yen trades another boost.

Then when the VIX appears to peak, and these stock traders are just beginning to make some headway in their trades; all I have to do is reverse my yen trade and I’m still making a killing the whole time. If they only knew it was so easy…

Take a look at the VIX in the chart below, and the Japanese yen price right above it. When the VIX hits extreme levels (above 30 but especially around 35 or higher), the yen starts to peak. At that time, I just reverse my trade and start shorting the yen.

The VIX and the Yen…Traveling Buddies!

As a currency trader, you can buy or short the yen based on what you see using the VIX, their so-called “stock tool.” If you’re a stock trader and you understand the VIX, then you also understand the yen whether you know it or not.

As you can see above, the yen’s run may be almost over because the VIX is showing an extreme reading (i.e. it’s soaring higher). So it may be time to reverse your Japanese yen trades.

Secret Weapon #2: Collect Daily “Dividends” from the Currency Market

But there’s one secret that would REALLY push my stock buddies over the edge if they knew about it. It’s one I use in “up” markets, when stocks are also doing well

Most traders know the S&P 500 hasn’t gone anywhere for a number of years. However, once you take into account these companies’ dividends, then you could have an overall gain even while stocks stay flat.
However, these stocks only pay out dividends on a quarterly basis, while currencies pay out interest on a daily basis. Yes, you read that right…

It’s like getting a dividend daily.

So I have 365 opportunities a year to profit, while my stock buddies get four. If they only knew…

Secret Weapon #3: No Commissions, So There’s Less Fees in Currencies

The third advantage I have over stock traders is my stock buddies have to pay a spread AND a commission for each stock trade, while I ONLY have to pay the spread.

And I pay a smaller spread than they do because I control more currency with less money down and because the currency market has more volume which leads to tighter spreads.

So while my stock buddies are trading in this bear market, losing money on their positions AND paying commissions along the way, I’m earning profits now and paying less in fees.

Let’s say my stock trading buddies and I place the same number of trades each year. My stock buddies pay a measly US$7 per trade (even though many firms charge more). If we both made only 10 trades each month, we’d both have 120 trades over the course of a year.

Now remember that stock traders are charged twice on each trade (when they buy and when they sell). So over the course of the year, my buddies must pay 240 different commissions, costing US$7 each. That’s US$1,680 in commissions. That doesn’t even count how much they also pay in spreads.

What do I pay in commissions for completing those same 120 trades? Nothing! I only pay my much smaller spread all year long.

My stock buddies have to earn that much more in profits before they even break even. So obviously, the deck is stacked in my favor. If they only knew…

You now know my three secret weapons that give me an edge in the currency markets.

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.

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 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.

On August the 8th, Russia declared war on Georgia. By the 9th, it was an all-out bloodbath. Reports show that over 2,000 people have died during that short time and over 100,000 people fled the conflict.

As you can see, war is never pretty.

This week, Russian President Dmitry Medvedev and Georgian President Mikheil Saakashvili are already planning to sign a peace plan. But still the damage has already been done – particularly to the Russian ruble.

Honestly, what happened to the ruble this week is pretty common during wartimes. So this begs the question: How does a war affect a currency?

Well, as I often say: Money hates instability. There is nothing more unstable and unpredictable than a war where anything can happen. You also never know how long one will last, who will win, and what will be lost along the way.

As an investor, you’re left to suspect the worst. That’s why most investors grab their money and run to safer, more stable countries until the coast is clear.

Russia Declares War and
the Ruble Sinks 4% in 5 Days

To this day, Russia still has a bad reputation for decades of shady dealings. As such, investors never seem to fully trust the Russian markets. If a conflict breaks out, investors rush in and grab their cash even faster than they would another country.

And that’s exactly what happened when Russia declared war on Georgia.

Check out the chart of the U.S. dollar vs. the Russian ruble below. You’ll notice the ruble tanked over 4% in just 5 days after war broke out.

With Leverage, You Can Turn that 4% move into 400% Profits

Now that may not seem like much to you. But you have to remember that small movements in currencies add up to a lot in trading accounts.

Spot Forex accounts are commonly leveraged 100 to 1 or even 200 to 1. So a 4% move can be magnified to equal a 400% to 800% move in just 5 days.

If you bet against the ruble just as the Russians declared war, then you would be sitting on some healthy profits right now. However, if you bought the ruble formerly because it has done well in this “energy/commodity” boom, then you probably watched your account sink into the negative territory over the last few days.

Most trading accounts can’t take 400% to 800% losses on their positions over a five-day period and survive.

So ruble traders really had a wild ride since this began.

Is the War Over Yet?

Let’s suppose for a moment that the war truly is over and things somewhat revert back to normal (a Russian normal anyway). If that happens, then Forex traders will probably see it as a buying opportunity and grab the ruble once again at bargain prices.

However, if the conflict isn’t truly over, or if another one erupts, then you will see the rollercoaster ride begin again.

It takes a strong stomach to invest in the ruble right now. Much of the time it has been a very profitable “one way bet” against the buck since 2003. However, in times like these, you never know what the Russians are going to do.

On the other side of the coin, if you’re pulling money out of Russia, you’d better hide behind another BIG country. So many traders ran to the U.S. dollar since it’s the “Big Brother” that might be able to protect them and their money.

However, other traders chose to run to the “risk adverse” currencies of the Japanese yen and the Swiss franc. Both of these currencies have torn a chunk out of most currencies over these same five days with the exception of the U.S. dollar.

Right now, the buck can’t seem to do anything wrong and is rallying against any currency I have on my screen.

So war really “stirs the pot” because it not only causes money to run away from the country at war but also it has to find a hiding place. That hiding place won’t be the same for every investor. It may be two or three of the other biggest currencies in the market.

Bottom line: Money tends to run for cover at the first sign of conflict and tiptoes back in later after the conflict ends. Something to keep in mind the next time a war breaks out…

Dollar Rally Won’t Last Forever

Fundamentally, there is nothing to support a long-term U.S. dollar rally. 

Unlike 1995 when the dollar established a secular bear market low against major currencies, this uptrend will inevitably run out of gas.

Bear market rallies appear quite convincing and can muster significant strength over a short period of time. But this one simply has no long-term muscle.

Let me explain. In the late 1990s, the United States posted consecutive budget surpluses, enjoyed massive foreign direct inflows and low consumer prices in an environment of accelerated disinflation. No major military conflicts occurred and oil prices crashed to US$10 a barrel by late 1998 amid the Asian economic crisis and the collapse of hedge fund Long Term Capital Management.

Today’s U.S. and global macroeconomic scenario is nothing like it was 13 years ago.

Soaring deficits, two major military conflicts, a distressed consumer, rising unemployment and a bear market in housing won’t lend support to a secular dollar rally. In fact, Bill Gross, PIMCO’s bond king, predicts lower interest rates in the United States over the next several months as deflationary pressures continue to drain economic growth. Lower rates won’t support the dollar.

Remember the Credit Crunch?

The Fed is in no condition to raise borrowing costs despite high inflation. The ongoing credit crunch has not abated with overnight borrowing costs still elevated and mortgage-backed securities still clogged.

Over the last 30 days the stock market is up almost 8% but most credit indices remain at the same level or lower ever since Treasury Secretary Paulson guaranteed Fannie Mae and Freddie Mac wouldn’t fail.

That tells me credit markets are still far from stable as the economy remains fractured across key industries like housing, retail, autos, and airlines.

The big news this past week was definitely the dollar. The dollar rallied the most against the euro than it has in the past eight years. The dollar index climbed the highest it has been in six months.

So the question is: What’s going on here? How can the dollar rally like this when the greenback’s fundamentals leave so much to be desired?

Let me give you my theory about what’s happening here. To really understand it, you need to start with a question:

What happened to decoupling, the idea that other economies are immune to the United States’ weakness?

Well, it seems the sub-prime fiasco created bigger problems for the U.S. financial system than everyone thought. And now we’re seeing this economic virus spread to other areas of the globe.

Need Evidence? It’s All on the Nightly News

It’s pretty easy to see other countries are feeling our same sub-prime pain. Just look at these recent news stories…

• German industrial orders dropped sharply - by 2.9% in June. That’s disconcerting considering Germany’s economy makes up one-third of total Eurozone output. And speaking of the rest of the Eurozone, many of those economies are bogged down by housing busts just like us.

• The International Monetary Fund (IMF) called out the U.K. economy. They predicted the U.K. would grow 1.8% and 1.7% for 2008 and 2009, respectively. All I have to say is: Kiss those numbers goodbye. The IMF’s latest forecast calls for a seriously lower 1.4% in 2008 and 1.1% in 2009.

• Australia is battling sluggish household spending and their financial sector is being challenged. The National Bank of Australia recently reported a huge second quarter write-down, which they blamed on massive collateralized debt obligations (CDOs).

• And the New Zealand Treasury anticipates a second consecutive quarter of negative GDP growth. By definition, New Zealand will have entered recession once official numbers are released. They’d be the second OECD-member country since Denmark to sink to official recessionary status.

The reality is that the big three in the developed world - the U.S. the U.K., and the Eurozone - are staring into the face of recession.

How Does this Big 3 Recession Affect the Next “Superpower?”

As we were so often told when analysts were pushing the decoupling theory, China is set to take over the world.

But if weakness is spreading around the globe, what does that mean for China?

The 2008 Summer Olympics are just now beginning, and there’s news that pollution has grown to far worse levels over the last few months. Chinese officials are putting all kinds of limits on how many cars can be on the road on any given day.

Additionally, in an effort to minimize excessive air pollution, Beijing is closing 105 factories. And should conditions worsen, neighboring cities could close as many as 117 factories combined.

Anticipation of the games gave Chinese companies reason to ramp up production. But what’s concerning is these companies front-loaded production and an inventory glut is building up.

It makes you wonder how much extra production was jammed into the last quarter in order to prepare for air cleansing before the great games began.

I suspect plenty.

That’s never good because they will have to sacrifice growth for as long as it takes to work through the oversupply.

Aussie Dollar Slips Under US89c

Whoa. While we slept off our stupid allergy over the weekend, the Aussie dollar went into free-fall. No-one wants to buy a currency at the top of its interest rate cycle. It’s trading below US89 cents this morning.

If you find yourself standing around a water-cooler this week with financial buffs, make sure you have something to say about interest rates. Otherwise there might be an awkward silence or two. This is what’s driving the currency markets at the moment. Rate speculation.

Why Currencies Are Easier to Trade Than Stocks

If you’re looking for what stocks to buy, you have over 13,000 publicly traded stocks to choose from right now.

That’s a lot to weed through and it significantly drops your odds of choosing a winner. Even the best of stock pickers don’t always screen for the exact combination of things that you would look for in a stock.

However, in the currency world, there are only eight major currencies: U.S. dollar, euro, British pound, Japanese yen, Swiss franc, Canadian dollar, Australian dollar and the New Zealand dollar. So this makes about seven major pairs when paired against the U.S. dollar.

If you’re trading in the FX market, you could technically also pair these currencies with other currencies besides the U.S. dollar. But even then, you only have 15-30 pairs to choose from - compared to over 13,000 stocks.

In other words, you don’t have to watch thousands of currency pairs, because the pairs are such “macro” instruments.

This makes things simpler. All you have to do is pay attention to the most important data that comes out each day on those eight currencies. The economic announcements for a country can easily be found on an economic calendar at www.dailyfx.com or www.forexfactory.com.