Across the board, expectations of low global growth rates pushed down the demand for the world’s major commodities, with oil most prominent among them. While the Aussie came off of lows yesterday against the dollar, it slid today against that currency and continued what is now a five day downhill streak against the Yen.

This last trend was compounded on Tuesday by boasting coming from Japanese ministers that Japan will be the first G7 nation out of recession.

Across the globe, crude’s drop below the forty dollar mark was bad news a number of currencies. The Russian government was forced to inject some steroids into the rescue efforts of their currency. That, however, couldn’t slow the slide of one of the world’s most endangered currencies as traders continued to bet on further devaluations by the Russian government.

That being said, the apparent resolution to the Ukrainian gas line crisis will surely allay fears of over the ruble for at least the immediate short term.

Just as the two countries’ climates resemble one another, Canada’s currency has been feeling the same pinch as Russia’s. Most strikingly, the vaunted Canadian trade surplus has almost vanished, falling to a mere $1 billion. The psychological impact of this fact combined with crude’s flirtation with the $40 mark to put considerable pressure on the loonie. It’s currently trading at roughly 1.22 USD.

Bloomberg’s survey of economists predicts a fall to $1.25, though economists at the RBC predict a more dramatic drop off to the $1.31 range.

Speaking of striking predictions, UBS is advising investors to sell euros and buy dollars to get in front of the ECB’s January 15 meeting – one day after my birthday: give me a .5% cut, boys… seriously, you’re economy is in horrid shape, give yourselves an early birthday gift in the form of a .5% cut, for the love of God, you inflation-paranoiac freaks.

UBS’ predictions, though, didn’t stop the dollar from falling against the euro to roughly $1.32 in the face of an expected weak retail sales report.

What’s a bit surprising right now is UBS’ prediction of the euro a decent amount against the currently-battered sterling.

Risk aversion is baaAaack, and has been pushing the dollar back up from its Gaza-inspired lows, with the same UBS fellows – an overconfident bunch, methinks – also lowering their call on the dollar/yen to 90 from the initial 95.

The topic of risk aversion – it’s almost like we didn’t have a New Year – brings us back to the commodity currencies. A Seattle bank’s suspension of dividends reaches across the Pacific, apparently, because investors that the previous day had been feeling comfortable with risk enough to put money into the Aussie quickly retraced their steps, bringing money home to the dollar.

Similarly, New Zealand’s kiwi fell to just 48.62 yen, a four-week low.

The cause of that Seattle bank’s woes? You guessed it: residential mortgage bonds. Shouts of “happy New Year, everyone” should be delayed until August, or until the new treasury secretary decides to get a clue a require banks to be lending all of the capital injections they receive.

There have been manifold consequences for the forex market during the otherwise thin trading days of the Christmas-New Year week. The long term effects may be minimal, but for the first week of 2009, related speculation will be partly driving the market.

The main source of volatility has been fears that violence in the region will continue to the point that Arab countries disrupt oil supplies to the United States. The US stands alone in the international community in its support of heavy air strikes in residential Palestinian communities.
Like other highly visible media events, speculation has driven the market far more than actual concerns over oil market disruption. The probability of anything beyond symbolic oil market disruption actually occurring remains tiny.

For the forex market, 2008 closes on an appropriate note, with political events driving the market. With the volatility caused by this year’s oil markets and the subprime-related market crash, forex traders have turned their attention towards governments as the only institutions large enough to be at all capable of resolving the year’s crises. Within this environment, oil markets have reigned sovereign over the forex market. Indeed, Bloomberg recently found a correlation of .9 between the oil market and the US/Euro price. A correlation of 1, of course, would mean that oil prices perfectly predict the price of euros in dollars. A 90% predictive ability, though, ain’t bad. It’s an astounding statistic, really. For all the wild ups and downs the US dollar has endured this year against the euro, a forex trader would only have had to watch the price of crude, act accordingly, and he would have been right 90% of the time.

When a correlation is so strong, social scientists are trained to look for multiple sources of causation. This case is no different. First, there is the primary market fundamental: As the world’s largest oil importer, the United States will feel a drain on its currency increase as the cost of its largest import goes up.

That’s always been the case, though. What’s more important – and can pressure the dollar in opposite directions, depending on the circumstances – is the flight to safety dynamic that has dominated most of the year. Sometimes, when geopolitical crises hit, oil rockets upwards and investors fly to safety, which often takes the form of purchasing treasury bonds.

If the crisis is big enough to take down much of the global economy, though, the third major oil-dollar/euro dynamic emerges: Oil prices dives due to the fall-off in long term demand that results from contracting economies, and investors’ flight to safety instincts still dominate. So, the dollar goes up and oil goes down. This scenario is what we saw for much of the year, as the global crisis – subprime-related stuff – didn’t cause many geopolitical worries.

Getting back to the current crisis – wherein the first and second, but not the third, dynamic has predominated – the effects have been felt in many more currencies than just the US dollar. Holders of Norwegian krones, for instance, couldn’t be happier. Similarly, investors worried that the dollar was overbought funneled most of their flight to safety instincts into the gold market, thus fueling a rise in the Aussie.

It’s important to emphasize that this crisis will likely abate quickly and the forex markets will return to normal after a quick adjustment. Until Israel stops its bombing, though, there will be downward pressure on the dollar, perhaps even to the point of it becoming notably oversold.

For all the talk, though, few people have an accurate picture of what actually happened during the early depression years.  Traders need this background.  Without it, government decisions and economic news has no useful context, and traders just end up following the market perception of events, instead of leading it.

Online Forex Trading has written earlier about the parallels between then and now.    With those in mind, what is most important for traders’ purposes is the chronology of events.  Did leaders react swiftly and purposefully, or were they forced into their actions, eventually stumbling onto solutions?  Investment is all about timing, and knowing how the past played out is necessary to have an accurate prediction of the future.

We all know what is happening in the private economy right now.  Without government intervention, we will enter a massive depression:   Events compound themselves so strongly that the recession develops an unbreakable path dependency, systematically fueling itself in a lengthy, painful cycle. What’s important, then, is the government response.  While we can’t predict the future on this page, we can give you the story of how a similar Democratic Party – in a similar power situation and facing a similar crisis – responded.

An important part of the equation is Congressional-Executive relations.  On the one hand, the presidency was far less powerful then than it is now.  On the other, though, President-Elect Obama comes to office as a far more minor figure than FDR, and facing a Congress that, while deferential, will dictate policy in the areas it chooses.  Anyone that thinks Tom Daschle will be writing the healthcare legislation, for instance, has never seen Ted Kennedy angry.  Tom Daschle may be the next HHS secretary, but he’ll be sleeping in a human size cage in Ted Kennedy’s office if it so pleases the Senator.  So, we shouldn’t be too surprised if Congress and the President end up having roughly the same levels of influence over economic legislation now as they did during the Great Depression. Next up are the issues.  The dynamics of discussion have changed, in that state bureaucracy and the social sciences are far more developed now than they were then.  The issues themselves, however, are strikingly similar.  Government stimulus is the single most important variable; debate over the regulation of union activity is a front-burner issue – especially for the long term health of the US dollar; etc.

How, then, did the Democratic government respond when it finally came to full power in 1932?  Everyone has heard of the Hundred Days.  They were just the beginning, though.  The New Deal is often treated as this singular concept that one day was just injected into American political economy.  The reality, however, is that it evolved as fast as the events did.

Like nowadays, labor unions were an important but secondary player in the Democratic Party when Roosevelt came into power.  Like Obama is doing now, Roosevelt started off putting his government firmly in the hand the corporations that had previously dictated policy, but told them action was necessary. The most important early act, perhaps, was the creation of the National Recovery Administration (NRA).  Business leaders regulated themselves, politicizing economic conflicts.  The NRA was a miserable failure, and probably did just as much harm as good.  Importantly though, section 7(a) of the act that created the NRA spurred considerable union activity.  By the mid-thirties, labor had replaced business as the primary ally of the president.

We are in a similar situation with the union bill that Congress will take up as soon as Obama is sworn in.
In areas outside of agriculture, it wasn’t until the mid-thirties that FDR’s administration got serious about its New Deal.  The Wagner Act and the Social security Act were both passed in 1935, and the Fair Labor Standards Act of 1938 created a modern system of industrial relations.

Look for a similar pattern this time around.  Obama’s picks for the most critical government positions could well have been picked by a Republican.  The consequences of the policy changes they will be forced to make, however, may fundamentally change the power dynamics in Washington.  Once that happens, however, change might start to flow from the executive branch as well as the few-and-far-between islands of responsibility in Congress.

Meanwhile, the value of treasury bonds remains sky high, with traders digesting the now-fully-developed consensus that this recession will be the worst since the Great Depression.

In perhaps today’s most powerful illustration of the fundamentally unhinged — literally — nature of the markets these days, the forex markets reacted today to the horrible jobs report by buying dollars… That is, the jobs report was so bad that the flight to safety caused by the horrible-ness of the data actually outweighed the normal effect of the horrible-ness of the data.  It’s a dynamic we’ve all seen before, but rarely to jobs reports.

With the behavior of libor returning to something approaching normal, it’s not as if the dynamics today are those of the pre-TARP disaster time are the.  With Congress moving to aid the automakers, and speculation on the stimulus package moving up to the $700 billion range, investors are not especially worried about governments responding aggressively to the recession.  Rather, the macroeconomic data is just so horrendously bad that the worry is whether or not governments will even be able to spend their way out of prolonged retraction of most major economies — and that has left investors with few places to hide.

There has even been talk of a bubble in treasury bonds — talk that surely is not good for the US dollar in the long run.

Large drops in the price of oil led to a rally in US stock markets and a dive in the Loonie.  The effect of today’s drop in commodities, of course, has little effect on the US economy in comparison to the massive job losses.  It’s an additional sign, however, that markets are behaving in a mode that can only be described as systemic panic, however much investors try to put a positive sign on it.

Much as a person prone to delusions is prone to moments of mania, so have the markets reacted with mania to any significant positive news the past week.

The lesson for forex traders is this:  Generally speaking, markets have become far from efficient information filters these days.  More specifically, things have gotten so bad that flight to safety will keep the dollar strong for the time being, and .  When the dollar does begin to fall, though, that will be a sign that global the flight to safety is nearing its end.  At that point, large institutional investors would rather be caught dead then holding T-bills.  Look for much of that capital to leave the US; and look for the dollar to depreciate sharply against the euro.

A quick review of the pertinent events: The BOE monetary-policy committee voted unanimously to cut rates 1.5% after the consumer price inflation rate basically entered free-fall, dropping .7% in one month. It was announced Japan’s economy has been receding the past two quarters. US housing starts fell to their lowest level in about fifty years. More importantly, consumer prices plummeted 1% in just one month. Citigroup’s goose is apparently cooked, requiring another bailout. Finally, chances of a bailout of Detroit appeared to slide, as Congress decided to play pretend-economics and lose far more than $25 billion in tax receipts and unemployment benefits instead of on a loan that would ultimately be repaid.

In short, this week brought about some very, very, very bleak news. And that has created real fears of sustained deflation.

Importantly, the creation of those fears was immediately preceded by a massive build up in government debt.

Right now, most governments would prefer inflation to be around 6-7%, spurring a little private investment and at the same time dropping the cost of their debt.

Instead, we are facing the possibility of negative rates of inflation for at least the next quarter.

What all of this means is that you should erase any skepticism that the next round of government stimulus will be huge. Private demand for debt is nose-diving, and each dollar governments spend stimulating the economy right now will be heavily discounted by the upward pressure it puts on inflation right now – and it will take a lot of spending to bring inflation back up to where it should be.

One interesting factor here: That logic doesn’t apply as fully to EU governments, who not only won’t get the same inflationary benefit to their spending due to their multi-national currency, but also face notable debt ceilings that the ECB will, to some extent, use as leverage (no pun intended) to keep governments from spending too much.

The US and the UK, however, are different stories. On top of the BOE’s massive rate cut, the BOE signaled future cuts to be all but inevitable. Look for fiscal policy in the UK to take the same policy: the no-one-cares-about-inflation-because-we’re-all-gonna-lose-our-jobs-if-we-don’t-keep-this-recession-from-getting-too-deep policy.

In the United States, the President-Elect signaled today in his weekly You Tube address that the stimulus will be on the larger side of things. Starting his message off by rattling off some of the week’s terrible news, he noted the risk of deflation and then devoted the rest of the message to an argument for a large stimulus package, “a two year, nation-wide effort to jump-start job creation in America.”

Much of the makeup of the bill seems to be focused on his campaign promises to rebuild infrastructure and jump-start a domestic green energy industry.

It’s not a coincidence the President-Elect’s announcement focuses on the gravity of his stimulus package one day after he rallied the markets by announcing Giethner will be his Treasury Secretary. It’s part of a coordinated plan to reassure markets that aggressive action will be taken as soon as a functional government comes into office.

What does it all mean for the forex market? A column written on this page last week expressed skepticism that the stimulus will be large enough to meet the challenges ahead and thus give a boost to the dollar. This week’s events, however, have made it more likely that the stimulus will be larger than the $300 billion number being thrown around by analysts at Goldman Sachs and other companies.

It would still be surprising if it were to exceed $500 billion, but after this week, it is a much safer bet that the announcement of the details of the stimulus package will lead to a notable and immediate uptick in the value of the US dollar.

Today, Bank of America and Barclays Capital have made similar suggestions. 

It’s not surprising few observers weren’t crowing about the strong medium and long-term strengths of Australia’s dollar.  The currency has been absolutely battered on several major fronts.  Commodities have taken a nosedive, of course.  That coincided with a major flight to safety in the wake of the credit crisis.  Both New Zealand and Australia saw their economies seriously damaged by traders looking to get out of anything close to risky bets.

The Aussie, however, has an interesting relationship with global crises.  On the one hand, investors will leave the small, comparatively volatile economy in the blink of an eye when crises hit.  Yet, the Aussie is most closely tied, in the long run, to the price of gold. 

That commodity, of course, sky rockets during times of instability.  Indeed, 2008′s manic-depressive swings have combined with several other long-term factors to push gold to record heights. 

That sets the stage for a potential rally in the Aussie.  Since June, the Aussie has been nose-diving, declining the most of the top 19 currencies vis-a-vis the US dollar.  It is now either at or within three or four cents of a genuine bottom. 

That really sets the stage for a rally. 

China, of course is Australia’s biggest importer of commodities, and that country just announced a $500+ billion stimulus package.  

That huge bit of news finally peaked the interest of the big institutions.  About a week later – today – they found that the Australian economy will probably not reach a full recession, with the Bank of America report arguing that the economy will likely just barely recede during one quarter next year. 

It’s not too often you can say this:  The Aussie is perhaps the safest bet you could make right now.  You could buy now to be sure to beat the crowd.  Or, preferably, wait for one more dip in the next several weeks, and then move when it’s at it’s very lowest.  Once it gets close to US $.60, buyers will definitely start swooping in.  The currency will likely rise 15-20% against the dollar in the medium term, and may continue to look strong after that.

This weekend, two major facts were made clear:  (1) Congressional Democrats are waiting for George W. Bush to finally leave the world stage before passing a major stimulus package and (2) world leaders are waiting for George W. Bush to finally leave the world stage before starting major international talks on policy coordination.

The man may not be an idiot, but if he’s not, he’s definitely a nihilist.  It’s one of the other.

At any rate, the delaying of a large stimulus package is hopefully this president’s last major act  of mis-governance, and his last chance to harm the US dollar’s forex standing.

The major sticking point to a smaller, stop-gap stimulus bill right now is the potential bail out of the auto industry.  Republicans are pushing back against a redirection of roughly $25 billion from the TARP to the auto industry.  They are aiming to force GM and other Detroit makers into official bankruptcy in order to sideline the United Auto Workers union, one of the nations most progressive and politically effective major unions.

Few analysts outside the halls of Congress can say for sure what will happen, but it seems likely that a Detroit bailout-less stop gap stimulus measure that is a little more than half the size of the $61 billion bill the House is going to pass this coming week will become law during the lame duck session.

After that, look for a huge stimulus measure to be passed in the first week of the next Congress.  The overall size will be an important matter.  The range being debated right now seems to be $300-600 billion.  The larger the bill, the better for the economy – in both the short and long term – and the better for the US dollar, especially vis-a-vis the euro.

A $300-400 billion bill would provide a slight bounce to the dollar, especially if action in Europe is constrained even partially by the ECB’s desire to stick to its debt ceilings.

If truly good news actually comes out of Congress, though, and political leaders choose to actually respond appropriately with a $500+ billion stimulus, look for the dollar to rally against every major currency in a significant, if fleeting way.

Much will depend on how the news breaks – and on the remaining Senate races.  Regardless, expect the psychological impact of a $500+ billion stimulus bill to give it an effect on the forex markets above and beyond what will be priced into the markets in the days prior to the publication of the final details of Congressional agreement on the size of the bill.

Let’s make a more in depth comparison, so we forex traders can bring a more suitable historical context to our reading of today’s economic details. 

First things first: Here is the GNP data for the US economy during the pertinent part of the Great Depression:

1929    $104.4

1930    $94.4

1931    $87.8

1932    $74.8

1933    $72.7

1934    $79.5

1935    $87.8

1936    $99.5

We can see from these numbers that, in terms of the macroeconomy, things were in near total free-fall from 1931-1932.  That’s an important point.  While both todays and 1929’s initial shocks to the economy were of the same general magnitude – 2008’s was actually greater – what morphed the Great Depression from recession to depression was the US government’s inept response.  Not only did Hoover prove to be one of the country’s worst presidents, the Democrats were just starting to feel their way towards Keynesian economics. 

A good example of the government’s incompetence during the beginning of the depression can be found in the debate over agricultural dumping policies.  A bill proposing the government dump excess corn and cotton was rejected by the Hoover Administration, despite the obvious need for such a move.  Then, in 1930, the Smoot-Hawley Act was passed, creating tarrifs that everyone knew would lead to retaliatory measures from countries to which we imported our cotton and corn.  The result was the government being forced to buy, and then dump, those same two commodities to make up for a flooded domestic market.  Losses from the program were around $300 million.  All the pain, with none of the gain. 

When the Democrats came into power, they began to right the ship of state, but their programs failed to put an adequate dent in the labor market problems in the short term for two reasons.  First, mainstream economists now agree, they were far too modest.  Second, as they began to slowly work, Roosevelt beat a retreat back to conservative economic principles – a focus on a balanced budget, mainly – in 1936.  The result was another two years of a further deepening of the recession.

In comparison, today policy responses to recessions are considerably more developed.  We know what works and what doesn’t.  Even the Bush Administration responded on a scale the Hoover Administration never would have dreamed of, even if their economic policies are basically –even literally – being run by Goldman Sachs. 

More importantly, a responsible – that is, responsive – government is being swept into power just several months after everything started spinning out of control, not three years

Furthermore, there has been no comparable raising of trade barriers that would further deepen the recession, like the Smoot-Hawley act did at the beginning of the Great Depression.    

So, in conclusion, the initial blow to the economy was larger in 2008 than it was in 1929.  That’s about where the comparison stops, though.  The world’s biggest governments are responding with some mild degree of competence this time around.  China’s government, for instance, is spending over $500 billion on a stimulus package.  Hopefully the US will follow suit immediately. 

It will be a depressing sign – Ooooh! Pun! – if the stimulus bill is only $300 billion.  That is the bare minimum needed right now, and would be a sign that the new government is favoring political moderation over genuine policy concerns.  Even if that’s the size of the final bill, though, the fact that it is happening now will make all the difference, at least in comparison to 1929, and we will likely not see a full depression in this country.  If the government acts wisely, it can even avoid a late seventies/early eighties type of malaise. 

I’ll believe that when I see it, though.   

Nowhere was that more clearly on display than in the “race to the top” that occurred between American and European finance leaders several weekends ago.  Europe’s stronger banking and credit guarantees forced American policy makers to match European national absorption of risk.  If treasury and the fed hadn’t followed suit, a major capital flight from the country would have been caused by private American institutions moving liquidity to European markets in order to take advantage of government guarantees across the pond.

Those decisions were, at their heart, political.  Treasury and the fed had been moving aggressively, but in a fashion that reminded more than a few observers of the actions taken by the US government before the great depression.  Specifically, their actions were significant but highly “bounded by ideology,” in the words of Theda Skocpol, a previous president of the American Political Science Association (APSA), and scholar of the New Deal.

So, in a disconcerting environment, the mainstream sentiment of political scientists and economists was one of further concern over the actions of the US government acting in a manner not strictly guided by technical economic and political economic analysis – until the Europeans forced  Paulson and Bernanke’s hand.

In such an environment, the market moves dramatically due to variables difficult to analyze and far from the range of expertise of most traders.  What happens in this scenario?  Trading risk goes up while potential pay-off stays roughly the same.

Which brings us to much of the flight to safety of the past month.  Yes, the vast majority of it has been the result of large-scale traders and institutions moving to safe investments.  Investors of all scales, however, have been feeling less than confident about their ability to successfully ride the political waves that have been washing over the market recently. 

So, it’s not a surprise there have been a lot of questions about good, safe places to invest your money until  the “economy” part of “political economy” can once again become the prime determinant of the dynamics of the forex market.   

Where to put your money for genuine safter is a tough question to answer these days.  The traditional major sources, gold and the US dollar, aren’t as clear-cut right now as they were several weeks ago.  Though gold’s seen better days times than this week, it’s still relatively close to historic highs, and is one of the more politically sensitive commodities. 

With Libor softening significantly as government money starts to really flow into the credit markets, it’s clear that some semblance of normalcy is just starting to return to markets, at least for the time being. 

Costs of money are falling, and some of the markets that got really battered recently are good bets.  In a couple months time, for instance, start keeping your eye on the Aussie.  After this week’s rise, we might want to be skeptical about how long investors will be truly comfortable with higher-yielding assets .  After a couple of months of tepidity, though, investors might start warming to a gold-powered Aussie.   

The US dollar’s strength and potential for a softening makes it hard to recommend treasury notes right now.  For at least the next three to four weeks, the Euro will probably be the most stable place to put your money.  At that time, let’s see where oil is.  If it takes another hit during that time, it might be time to flirt with that commodity for a bit.

Similarly, in six month’s time, it’s likely the market will have priced in almost all the commodity softness from a major economic downturn, and the Loonie will probably begin looking set to stage a bit of a bounce-back  from its recent free fall. 

So, in conclusion, look to those currencies and other investment opportunities that are most battered but whose future existence isn’t in question.  Don’t be afraid to be an active investor right now, but keep with conservative estimates of global economic health until at least 2010.   

The euro fell against a wide variety of currencies, including the pound, US dollar and a basket of Eastern European currencies.  Hungary’s forint was the big winner, beating back the flight to safety and concerns that the global economic slowdown would be particularly harsh on the Hungarian economy.  Today the forint posted  a massive 3.8% gain.  Most Eastern European currencies edged up less than 1%, with the  Czech korona being the only major loser, falling .7% against the euro.

There is little doubt, though, that the region’s currencies won’t be able to hold up for long, at least against the euro.  Access to credit will be particularly scant for the region’s businesses, and several bond agencies announced today that they are reviewing the region’s governments’ debt with an eye towards possible downgrades. 

A similar fate fell on South Korea’s won on Thursday, as S&P warned that many of the nation’s banks may be unable to refinance their debt. 

New Zealand and Australia’s  currencies also suffered from concerns about how vulnerable their economies are to a global recession.  Today’s events reinforce a suggestion made earlier on this page:  After the Australian currency bottoms out in the near term, look to place some long-term money in the Aussie, as the price of gold starts to make the currency look very attractive again.

The Canadian and Russian currencies, meanwhile, took a tough beating this week as oil tumbled to below $70 a barrel for the first time in recent history. 

Norway’s currency took a similar hit on the forex market, losing over 3% of its value on Thursday against the dollar. 

South America’s economies fared better on Thursday, as Mexico and Brazil’s central banks stepped in and purchased each over two billion and one billion dollars worth of their currencies, respectively. 

That being said, earnings season may be tough for the real, as currency fluctuations and poor forex decisions throw off domestic firms’ third quarter profits.

In all, much of the shifted trader attention can be attributed to chairman Bernanke’s purposefully dour assessment of economic fundamentals.  This re-orientation of market focus can be seen as the fed chairman’s way of smoothing out the inevitable fall in US markets resultant from the coming horrid macroeconomic news. 

Be wary of the commodity currencies, and watch for a few short spikes in the euro over the course of a longer decline versus the dollar.

The economic fundamental news will continue to dominate until the relief package begins to be actually implemented.