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U.S. Benefits from Fear in Fragile Financial Markets

The U.S. Dollar benefited again on Tuesday as global investors fled risky assets for a second straight day. This current flight to safety rally is being triggered by worries about the U.S. banking system and the world economy's ability to pull out of the current recession in a smooth and timely manner.

Negative comments from analyst Mike Mayo and George Soros on Monday are still weighing on financial markets. Mayo questioned the ability of the U.S. government to help banks recover from their exposure to toxic assets while Soros said the "banking system as a whole is insolvent."

Both of these comments sent investors fleeing higher risk, higher return assets back to the safety and security of the U.S. Dollar. Global investors are now thinking of return of investment rather than return on investment like they were earlier in the year.

Fear is driving the markets lower just like over-optimism drove the equity markets higher for the past month. Aggressive traders seeking higher returns played right into the hands of smart money that was watching the global economy. The recent rally was driven higher on expectations of an improved economy without any real evidence that the global economy was improving. Investors chased return out of fear of missing the bottom. This is how bear markets trade. Investors are going to have to get used to the fact that there is a new "normal" and if they want to play the long side, they have to settle for quick gains.

Although it may look like a lagging indicator, investors are going to have to wait for the economy to turn before investing for the long-run. Investors will also have to decide if it's safety or return they are looking for in the equity markets. The market gave a nice return to those that bought low and got out high. Now is the time for those who bought late or for the "new bull market" to pay the price for taking on the risk. The movement back into the Dollar is for safety. The new trader is going to have to learn how to shift his money back-and-forth between asset classes and between return and risk to make any kind of a long-term profit in these markets.

Following the money is going to be the key to survival in this current environment. Traders will dominate investors. Investors will have to realize there is no long-term. Professionals and financial institutions are going to be short-term driven. The edge is going to go to those that can follow the money between the asset classes. Right now the edge goes to those that can track the money flow between the safety of the Dollar and the riskiness of the equity markets.

The Euro continued to erode recent gains as traders focused on the weakness in the Euro Zone economy and the safety of the Dollar. Problems are likely to begin rising again in the Eastern and Central European nations that have been swept aside by the European Central Bank and other stronger European Union nations. If the U.S. banks cannot find a solution for toxic assets even with billions of Dollars pumped into the system then there is virtually no chance for these Eastern and Central European banks to handle a similar situation. Start watching for signs of problems in this area. This is the unknown factor that could hurt the Euro.

The stronger European Union nations are already on record as saying they will not bailout these banks. Last week's G-20 summit calmed fears of a financial meltdown for one day when it was announced that $1 trillion in aid would be provided to emerging markets. Unfortunately this was only a pledge that could months or years to fulfill. The emerging markets in Eastern and Central Europe need the money now or their financial problems will quickly spread across Western Europe.

Continue to look for erosion in the GBP USD as investors are now becoming more convinced that the economy is in worse shape than previously estimated. The housing market is the real key to a sustained recovery in the U.K. economy but with unemployment rising how could anyone afford to buy a home to start a recovery? The only movement I see in the housing markets is in refinancing existing mortgages.

Consumers are another key but they are most likely going to continue to hold on to what they have. Look for increased savings and less money spent on retail goods and services. Both of these should continue to put a drag on the economy.

The Bank of England is being careful with its use of quantitative easing because if done improperly it can have massive inflationary ramifications later in the economic cycle. With nowhere else to go with interest rates, the BoE is going to have to make some radical decisions in the near future to stabilize the economy or the system could collapse. The charts indicate there is plenty of room to the downside.

Scared money from falling equity markets found its way back to the Japanese Yen. Much of these funds were most likely Japanese investors repatriating funds earmarked for higher yielding assets elsewhere.

The Bank of Japan decided to stand aside at this month's monetary meeting. Since September 2008 it has tried to reassure the nation that it was doing all it could to revive the economy including cutting rates to the lowest in the world at 0.10% and applying quantitative easing in the form of government bond purchases. This time around it decided to watch and see if there would be any improvement in the economy without official interference.

The Bank of Japan along with the blessing of the Japanese government did announce a plan to expand the collateral required from commercial banks to secure loans. This move does in effect put more cash into the economy but does not have the impact of quantitative easing. Today's decision is designed to free up funds to encourage more lending. Tight credit markets are said to be one of the causes of the economic collapse in Japan.

The USD CAD traded mixed on Tuesday. Pressure from the decline in global equity markets hurt the market most of the day. Perceptions that perhaps the U.S. economy did not reach bottom or that banking issues will continue to plague a smooth recovery continue to weigh on the minds of traders.

Lower oil prices will be a factor that weakens the Canadian Dollar but losses could be limited if base metal prices such as aluminum, zinc and copper stabilize. Gains in gold also helped limit losses.

News that the government is seeing improvements in the credit markets and the retail sector were also reasons for the short-term gain on Tuesday.

Overall, however, the USD CAD will get its major clues from the U.S. equity market and crude oil. An eroding stock market will be a sign that investors still fear more downside for the U.S. economy. Investors would be encouraged to buy the U.S. Dollar for safety which would put pressure on commodities. Lower commodity prices would hurt Canadian exports and help shrink its trade surplus.

A slowdown in the economy would also hurt demand for crude oil which is already under pressure because of rising inventories. Clearly a bearish outlook for the U.S. economy will not bode well for the Canadian economy.

More flight to safety buying helped buoy the USD CHF. Strong gains the past few days for the Swiss Franc over the Euro may prompt the Swiss National Bank to try another round of intervention. If it does intervene, then look for a sharply higher Dollar.

The Reserve Bank of Australia cut its benchmark interest rate by 25 basis points. This was less than the market anticipated. Traders had been looking for at least 50 basis points but the RBA feels that 25 bp is enough to contain the economy.

The RBA refrained from a rate cut last month instead deciding to take a watch and see attitude. Although there are no solid signs of improvement in the economy at this time, the RBA must feel the economy is bottoming. The recent strong upward movement in the AUD USD was a result of higher equity and commodity prices.

Although the slight decrease in interest rates should have no real effect on the price of the Aussie, traders are watching for a return of risk aversion to drive the value lower. The RBA will be happy with a decrease in the AUD USD as this may encourage greater demand for exports. From what I have read the RBA was getting concerned with the rise in the Aussie because of its negative impact on exports but was unwilling to do anything to lower its value out of fear it would create volatility in the currency.

New Zealand is facing a similar situation as Australia. The NZD USD has risen considerably the past month because of the rise in equity and commodity markets. One concern of the Reserve Bank of New Zealand, however, is, did it rally too high to hurt the export market? This will not be known until end-of-the-month economic numbers are released.

At this time the RBNZ is walking a thin line. If the economy is recovering and it cuts then it may lead to inflation. If it cuts while the price is rising then the subsequent break may trigger unstable conditions in the currency markets and that will keep buyers of New Zealand goods away.

Taking a wait-and-see stance is probably the best decision at this time. The RBNZ has to be sure the economy is not being negatively affected by the rise in the Kiwi before it makes a decision. If it blows the call on an interest rate cut this month, it still has the option to apply quantitative easing or intervention.

Overall, the NZD USD should feel pressure because of the erosion of demand for risk by investors. This is the key factor traders are watching in the short run. Interest rates, quantitative easing, and intervention are all long-term factors which aren't on the minds of traders at this time.


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