Capital Flows ,Where the money goes ?

But honestly, that’s only part of it. The other reason there is always at least one currency rising is because of capital flows. As a currency trader, you’re constantly watching where capital is flowing, so you know where traders are dumping their money.

Every time markets suffer around the world, there’s always a line-up of investors ready to sell-off their positions.

Each time, those investment funds have to go somewhere. Even if that’s just back to cash – which pushes a handful of currencies higher. That’s exactly what happened in 2008. As investors ran from stocks, bonds and even CDs, certain currencies rose.

However, not all currencies (or markets) are created equal.

Currencies and the Law of Relativity

We live in a world made up entirely of fiat currencies. “Fiat” means “an arbitrary order or decree.” In other words, our money doesn’t derive its value from a particular good or basket of goods, but from the government decree that brings it into law.

So the value of these currencies isn’t fixed. Instead, it tends to fluctuate and vary, depending on everything from interest rates and policy decisions to exports and civil unrest. So if you want to know what a currency is worth at any given time, you just have to ask yourself, “What could it buy?”
 
A soda, a half-gallon of gas, a big mac etc. And we do the same thing in the Forex world when comparing currencies. A particular currency can only buy so many yen, so many Swiss francs, etc. 

So it stands to reason that if a currency’s exchange rate is falling, then another’s is rising. That’s the law of relativity when it comes to currencies. If the dollar’s exchange rate against the yen is declining, then you can buy less and less yen with your dollar. But at the same time, you’re able to buy more and more dollars with your yen.

This is where the idea of an eternal bull market comes from.

For all of history through the 1800s, goldsmiths were the world’s primary bankers. It made sense in those hard money days to keep your gold with the fellow who molded it into coins and acted as the community’s central cash register.

So here we have the goldsmiths…guardians of bullion and protectors of everyone’s wealth. I’ve personally always seen this as the primary function of a bank.

But just guarding money and issuing certificates for it…I suppose it just didn’t pay as well as it could. That and you always end up with a huge pile of cash (gold) that’s just sitting around and not really doing anything other than backing promissory notes. So the goldsmiths got crafty, and at this point they became the bankers we know today.

They started issuing more certificates than they could back in gold, allowing them to collect interest on the physical gold collecting dust in their shop…gold that already belonged to someone else. But weren’t there already certificates attached to that gold? Of course. But the bankers believed those certificates wouldn’t all be cashed in at the exact same time, so they could get by and no one would ever be the wiser.

This is the critical point in our story, and at few points in history has the difference between right and wrong been so very clear.

The value of goldsmith’s notes was in the gold behind them. So when they issue a new note backed by…well backed by nothing other than the supposition that they’d have enough inventory to pay it off if it fell through…they were engaging in wishful thinking, at best. Ladies and gentlemen, I give you irrational exuberance. At the very core of our banking system.

But how could the goldsmiths get away with such blatant counterfeiting? Didn’t anyone realize that they were pulling wealth from thin air, that they were trading worthless notes for valuable goods? Well, the governments knew. Why didn’t they do anything to stop the goldsmiths?

Put clearly; it wasn’t in the interest of the world’s ruling monarchs to stop them. King Charles II of England had his own con game going with the bankers…one where they traded him physical gold for sticks of wood (I’m not kidding at all…we’ll be covering government debt next week.)

So by complying with the government’s con games and ponzi schemes, the goldsmiths earned themselves a back-scratching from the world’s monarchs, received in the form of Fractional Reserve Banking.

Seven separate assets currently maintain an 85% correlation (or better) with the S&P 500 over the last six months.

This correlated group includes Reuters/Jefferies CRB Index, emerging-market bond spreads, and not surprisingly, the euro. I’ve been talking about the tight correlation between currencies and stocks for some time.

My reason is simple: As risk ebbs and flows, the amount of traders buying U.S. dollars also ebbs and flows - only in an opposite direction.

So that means, when the S&P 500 tested new lows and bounced sharply, the U.S. dollar did the opposite - the dollar tested new highs and fell back sharply. We watched this happen this past week. Then on Thursday stocks collapsed again. Stocks tumbled to new lows not seen since 2003, and dragged down the euro right alongside. Of course, the U.S. dollar index broke out to a new high.

These tight correlations often are simply risk, ebbing and flowing. But maybe we should look deeper to understand the true driving forces behind recent trends. If you look closer, you can see why these correlations are more dollar-bullish than you might think.

What “Tight Coupling” Really Means

Over time, the market process can consistently produce extremely efficient interaction among human beings in the marketplace, in the business place and in life.

I try to make it sound simple. I try to boil it down to the big ideas. But really the entire process and all that goes into it is extremely complex.

I’m in the middle of a book by Richard Bookstaber titled Demon of Our Own Design. He’s devoted an entire chapter to an idea known as “tight coupling.”

That idea alone explains the correlations I just mentioned. Tight coupling also explains why the financial system crumbled, why the global economy is sinking, and why the U.S. dollar is back in vogue.

Tight coupling is the design and labor that goes into building a house. Tight coupling is how rock climbers scale a mountain-side. Tight coupling is an idea that helps to explain the detailed processes that go into complex, everyday functions. It also explains why disruptions of these detailed processes can happen.

Tight coupling exists throughout the financial markets that currency traders stress over nearly every single day.

A good example would be the recent subprime-mortgage backed securities fiasco. Before the entire credit system went boom, there were quite a few things strung tightly together. These things supported the trend of issuing subprime mortgages, bundling them up with other assets and selling them to investors.

But then home prices started falling. Suddenly borrowers couldn’t afford loans. Bundled loans became less attractive. The market for this newly created product froze up. Losses started piling up for investors in these bundled assets.

And then investors isolated from these assets began losing on their investments. This happened as the tightly coupled financial industry became unwound and asset values of good assets and bad began deteriorating together.

‘Propagate’ is a good word here - it means to cause to spread out and affect a greater number. Bookstaber used this word on occasion to explain how market participants add to the complexity of the financial system, and how that can lead to accidents which can trigger a vicious downward spiral of asset prices.

And that’s all well and good. Even if you’ve not yet grasped the idea of tight coupling yet, you understand what’s happened with the subprime market by now. You also know that relatively solid assets have been impacted once subprime derivative participants, and the market, were no longer able to handle the complexity of what they created.

Gold is bouncing back. According to the World Gold Council, which has released its last statistics recently, the demand has surged on the third quarter: from the jewellery industry first, but also from investors through certificates and ETF’s.

The physical demand has surged in Europe and in the US, but despite those flows prices remained between $700 and $800 an ounce on the market during the last month. After several months of correction and sharp countertrends, the last 4/5 weeks have been a consolidation phase.

Despite the turmoil on the finance sector and the banking crisis, the equity markets’ plunge and the growing global recession, gold prices did not soar as it could have been expected. Indeed, the deleveraging of the hedge funds that have been facing large redemptions has capped prices on the upside.

Last but not least, the US Dollar strengthening and the lower concerns about inflation (as commodity prices all fell sharply) have weighed on Gold prices.

Technically, the price action found some support just below $700 (point D on the chart), which is a previous low level tested several times in 2007 (points A, B and C). The main support level, around $635, has not been tested. This level is a previous high posted in late 2005 and that became a new low several times in 2006. On the downside, gold prices are therefore well supported by those two levels ($700 and $635).

Click To Enlarge

This morning Gold is trading around $820, which is more than 16% higher than 12 days ago. A further rebound is expected. On the upside, the main resistance is the line that goes through the lower highs posted since the historical peak of March 2008 (points E, F and G). The target for the price action is consequently just below $900.

Click To Enlarge

On the short-term chart, the indicators argue indeed for a further rebound. First, the Bollinger Bands are bullish as sharp price changes tend to occur after the bands tighten, as volatility lessens, which is the case here (the bands therefore volatility tightened in November during the consolidation phase). Second, when prices move outside the bands, a continuation of the trend is implied. This is also the case here.

The MACD has also triggered a positive signal two weeks ago, and its rise shows that some bullish momentum is building up.

In this scenario, the level of $890 may be the target and the first significant resistance on the medium-term.

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.

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.

NEW YORK - Wall Street shares zigzagged to a mixed finish on Friday in a market dragged around by reports and speculation about the fate of two troubled financial firms, Lehman Brothers and Washington Mutual.
In a volatile session that saw gains and losses reverse several times, the Dow Jones Industrial Average ended with a modest decline of 11.72 points, or 0.10 per cent, at 11,421.99.
The tech-heavy Nasdaq rose 3.05 points, or 0.14 per cent, to 2,261.27 while the broad-market Standard & Poor’s 500 index managed a gain of 2.65 points, or 0.21 per cent, to 1,251.70.

LONDON - European stocks closed higher on Friday, with investors betting that the US authorities will ensure that failing investment bank Lehman Brothers finds a saviour and ease the pressure on the banking sector.
In London, the FTSE 100 index was up 98.3 points, or 1.85 per cent, to 5,416.70 points.

FRANKFURT - Germany’s DAX 30 rose 55.99 points, or 0.91 per cent, to 6,234.89.

PARIS - France’s CAC 40 jumped 83.59 points, or 1.97 per cent, to 4,332.66 points.

TOKYO - The Tokyo Stock Exchange’s benchmark Nikkei-225 index closed up 112.26 points, or 0.93 per cent, to 12,214.76 ahead of a three-day weekend in Japan.

HONG KONG - Hong Kong share prices closed down 0.18 per cent on Friday, as weakness in Chinese banks offset earlier gains in property developers and energy firms.
The benchmark Hang Seng Index plunged 35.82 points to 19,352.90

WELLINGTON - The New Zealand share market rose to end the week, the benchmark NZSX-50 index closing up 28.15 points, or 0.844 per cent, at 3361.68.

SYDNEY - Australian markets have received a mixed lead from Wall Street, although the price of oil fell again in a special trading session overnight whilst gold and silver rose.
At 0722 AEST, the Sydney Futures Exchange’s September Share Price Index contract was 50 points higher, or 1.02 per cent, at 4,975.
In news today, the Australian Bureau of Statistics will release dwelling unit commencements data for June.
Reserve Bank of New Zealand assistant governor Dr John McDermott speaks at an Australian Business Economists lunch on “Monetary Policy Issues in New Zealand”.
Base metals and uranium explorer Aluminex Resources Ltd is to list on the Australian securities exchange.
On Friday, the benchmark S&P/ASX200 was up 89.5 points, or 1.86 per cent, to 4,903.8, while the broader All Ordinaries added 85.6 points, or 1.76 per cent to 4,957.1.

NYMEX

In energy trading on Friday, crude oil briefly fell below $100 a barrel despite threats to Gulf energy supplies from Hurricane Ike, suggesting traders still believe a soft economy will keep driving down demand.
Light, sweet crude for October delivery ended Friday 31 cents higher at $101.18 a barrel, after briefly sinking to $99.99.
That was the first time oil traded below $100 since April 2.
In a special trading session on the NYMEX last night Australian time, crude oil fell to a six-month low and gasoline tumbled amid signs that refineries along the Gulf of Mexico coast will soon resume operations after escaping major damage from Hurricane Ike.
More than 20 per cent of the US’s oil refining capacity was shut, limiting fuel deliveries and prompting the Department of Energy to release 309,000 barrels from its strategic reserves. New York Mercantile Exchange electronic trading opened early today to allow traders to respond to Ike.
Crude oil for October delivery fell $2.18, or 2.2 per cent, to $99 a barrel at 4.26 pm (0626 AEST) on the Nymex. Futures touched $98.46, the lowest since February 26.
Prices are up 25 per cent from a year ago.
Gasoline for October delivery fell 10.86 cents, or 3.9 per cent, to $2.661 a gallon in New York.
Oil in New York has fallen 33 per cent from a record $147.27 a barrel on July 11 as high prices and slowing global economic growth reduce demand for fuels. Sales at US retailers dropped in August for a second straight month and July inventories at American businesses increased the most in four years, Commerce Department reports showed last week.

COMEX

Gold for December delivery rose $19 to settle at $764.50 an ounce on the New York Mercantile Exchange on Friday, after earlier rising to $770.50. It was gold’s first positive close in 10 days.
Other precious metals also traded higher Friday. December silver rose 24 cents to settle at $10.795 an ounce, while December copper gained 7.2 cents to settle at $3.194 a pound.

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.