In order to really understand the value of the U.S. Dollar, one must have a basic grasp of interest rate theory in relation to currencies.  Each currency in the world has an interest attached to it that is set by its Central Bank.  The manipulation of this interest rate increases and decreases the supply of a currency in the economy and therefore will either stimulate or tighten economic activity.  During the 2000’s, Fed Chairman Alan Greenspan kept U.S. interest rates at very low levels versus other industrialized nations around the world such as England, Australia, and the EuroZone.  These low interest rates in the U.S. led investors to flee from the U.S. Dollar in search of higher yielding currencies, which resulted in a very bearish U.S. Dollar run.  In this picture of the Euro, you can see the dramatic fall of the U.S. Dollar throughout the 2000’s.

In 2008, when the Global Credit Crisis really exploded in September of ’08, the currency market went crazy.  There was a mad rush into the U.S. Dollars as unprecedented fear caused investors to demand the safety of their capital above everything else.  From September of 2008 to March of 2009, the U.S. Dollar experienced a dramatic rise in value versus the Euro, Pound, and nearly very currency in the developed world.  The reason is because in times of complete uncertainty, the U.S. Dollar is the safest place to park capital.  Investors want assurance that their investment is safe, so they opt to place capital in low yielding but very safe investment vehicles such as U.S. Treasuries.

In March of 2009, the recession bottomed out.  Economic growth resumed in the developed world and it looked as though the worst was behind us, so investors began taking their money out of the safe, but very low-yielding U.S. Dollar and placing it in riskier currencies that were offering higher risk.  Thus, began another round of Dollar weakness.  Let’s take a look at another Euro chart.

The U.S. Dollar was very weak throughout the 2^nd and 3^rd quarters of 2009.  Then, in November of 2009, the Greek Debt Crisis erupted and send financial markets into a tailspin yet again.  Investor sentiment weakened around the world, and there was another mad rush into the safety of the U.S. Dollar.  The Dollar rallied significantly against the Euro from November of 2009 until June of 2010.

Once the European Central Bank finally stepped in to pledge bailout funds for Greece and other struggling EuroZone countries, investors again began to sell the U.S. Dollar in search of higher yield and the Dollar began to fall versus every currency pair.

This phenomenon of the U.S. Dollar doing well only during times of economic distress could be a long-term sign of bad things to come.  Currently, the only reason investors want to hold the U.S. Dollar is for safety.  There is no interest in it as an investment.  What will happen if the U.S. loses its place as a harbor of safety?  Investors already want nothing to do with the Dollar during good times.  What if they don’t during bad times either?  That could spell disaster for the U.S. Dollar.  A forex demo account can teach you how to take advantage of the volatility in the  FX Market.

But then another surprise hit financial markets.  In November of 2009, it became evident that Greece and several other EuroZone countries were in serious danger of defaulting on large amounts of sovereign debt.  The run on the Euro was merciless as investors began to question the very existence of the Euro.  There was talk of the Euro going to parity with the U.S. Dollar after it had reached the $1.5000 level in November, and there were even talks that the EuroZone may break up.

Finally, in late May of 2010, after months of speculation and political debate, the European Central Bank stepped in a created a bailout fund for struggling EuroZone countries.  It was now certain that no EuroZone countries would default, at least in the near-term.  This move by the ECB served to reassure investors, and the Euro finally found support at $1.1875 before beginning a magnificent rally in June and July back up to the $1.3300 area.  During the rally in June and July it appeared the EuroZone had survived the worst of the Debt Crisis.

During June and July, Greece, Spain, and Portugal each returned to capital markets and all three countries had very successful bond auctions.  In fact, they were each able to auction off full amounts at interest rates that were quite attractive.  This served to further support investor sentiment.  However, the true underlying crisis in the EuroZone is far from over.

First let’s examine how these countries came to near sovereign default.  When the EuroZone initially formed, one of the major incentives for small, economically weak countries such as Greece to join, was that they would be able to borrow money at near German interest rates.  This was very attractive because at the time Greece was being forced to pay a much higher interest rate in capital markets.

Now, as a EuroZone member Greece would be able to borrow lots of money at low interest rates, and this is exactly what they did.  The idea behind cheap money for weak countries was that these weak countries would be able to borrow money and develop strong economic and public infrastructure, which would make Europe much stronger overall, and as a whole they would be able to challenge the United States as a world power.  But things went bad…awfully bad.

Greece did borrow money, as did Spain and Portugal.  But they didn’t use it as they should have.  Infrastructure was never developed the way it should have been, and now these countries are sitting on mountains of debt they can’t pay off.  Thus, one of the requirements to qualify for bailout funds was these countries had to cut back on public spending significantly, which is causing quite an uproar among citizens.  These aggressive budget cuts have alarmed many economists, as they fear these austerity measures may weigh heavily on EuroZone growth in the 2^nd half of 2010, and in a worst case scenario even tip the EuroZone back into a quarter of GDP contraction.  Forex software used by FX traders has helped many financial speculators profit from the rise and fall of the Euro in the last year.

And this is the current state of the U.S. economic recovery—“unusually uncertain.”  During the last two years the United States and the Federal Reserve have done everything in their power to stimulate an anemic U.S. economy, but nothing has been able to really get the recovery to what is referred to as a “self-sustaining” phase.  At the self-sustaining phase, a Central Bank is able to remove economic stimulus.  In early 2010, the recovery seemed to be doing relatively well in the United States and speculation began to rise that the Fed would hike rates and remove stimulus as soon as the 3^rd quarter of 2010.

Then, Greece happened.  The sovereign default scare in the EuroZone punished investor sentiment around the world and caused a wave of fear to enter financial markets as the very existence of the Euro and EuroZone came into question.  Finally, in late May the European Central Bank stepped up to the plate and created a bailout fund for any EuroZone countries in danger of default.  This move by the ECB did reassure market participants as it became clear there would be no sovereign defaults in the short term, but by that point, the damage in the United States had been done, and economic recovery was beginning to stall.

After a string of positive economic data throughout the first half of 2010 for the United States, economic data started to strongly disappoint to the downside in June and July.  Consumer demand began to drop, employment started to fall again, credit markets remained tight, and retail sales fell.  Bad report after bad report began to emerge out of the United States.  It suddenly became clear in late June that the U.S. recovery was hitting a wall of resistance.

Then, as poor economic data continued to come out through July, it quickly became evident the U.S. recovery was in dire circumstances.  The Federal Reserve had released a historically unprecedented amount of economic stimulus in the last two years, and still it was not enough.  The economy was beginning to show signs of a possible contraction in the housing sector, which, in a worst case scenario, could lead the entire economy back into recession.

Thus, Fed Chairman came out in late July and stated that the Federal Reserve was ready to act in decisive action by unloading another round of quantitative easing into the economy.  The markets got scared.  The U.S. Dollar continued its precipitous fall, and equity markets began to falter as investors and forex brokers attempted to weigh the seriousness of the slow-down.  Now, in August of 2010, the economic outlook is “unusually uncertain.”  This is definitely scary ground to be on two years after the largest economic catastrophe since the Great Depression.

Last week they featured a story about a hedge fund called Magnatar, who they claim not only saw the mortgage meltdown coming, but were able to figure out a way to profit from it on a pretty incredible scale. It’s worth mentioning that Magnatar denies the claim in this story that they intentionally set out to profit from the subprime mortgage collapse.

According to the story, Act One of the show entitled “Inside Job,” Magnatar sponsored the creation of complicated and, ultimately, toxic financial securities backed by low quality mortgages, which they then bought insurance against so that when those securities became worthless, the insurance would pay out big.

At first glance, this is a fairly typical investment strategy called “hedging,” in which a company purchases one set of securities as a primary investment and then purchases a second set of securities that will pay out if that first set drops in value. In this way, the second set of securities essentially becomes insurance against a drop in value of the first set.

The interesting aspect of this story, and the reason it posits that Magnatar was actually betting on the collapse of the subprime mortgage market is that Magnatar was able to work out deals in which the insurance would actually pay out significantly more if the primary investment failed than the primary investment cost to begin with. Not only that, but the reporters suggest that Magnatar intentionally pushed for low quality assets to be bundled into the primary set of securities, expecting them to fail so that they could collect on the much larger insurance payout.

To better understand the concept of hedging, consider this example. Let’s say you thought Gold prices were going to go up over the next year and so you decide to invest in Gold. However, just in case some event occurs that causes Gold prices to crash, you decide to also invest in the U.S. Dollar, knowing that when Gold prices go down, the value of the U.S. Dollar tends to go up. This way, if Gold prices do go up as you expected, you’ll reap the rewards of your investment in Gold, but if Gold prices fall catastrophically, your investment in the U.S. Dollar will likely increase in value, preventing you from losing all your money.

You can listen to Act 1 of the radio show online at This American Life’s website.

It may be the new normal. The advent of computer or electronic based trading has allowed for millions of stock transactions per second and with the 24 hour fast paced news cycle available to us in many different formats, the stock market has changed in two important ways.

Stock Market Changes

First, market volatility has increased. With the potential for millions of transactions per second, stocks can move up or down by multiple percentage points in minutes and second, electronic based trading has allowed for anybody to be involved in the stock market.

Market Volatility

Let’s take a look at volatility. Who do you know that seems to be overly sensitive? They react to everything. Maybe they scream during scary movies or get angry over seemingly meaningless things. Although you may not refer to them as volatile, stocks are the same way. Some are more volatile than others. In financial terms, we call highly volatile stocks, high beta. A high beta stock reacts severely to market conditions.

Not only have stocks become more volatile but the stock market has as well. Over the past couple of decades, we can see swings in the market that happen much more quickly. This happens in large part because large stock trades can happen rapidly. Large investors can buy and sell millions of shares of stocks with the click of a mouse. It only takes seconds and trades this large can move a stock up or down dramatically.

Adding to this volatility is the 24 hour news cycle. On any given day you can watch one of the financial news networks and get a first hand glimpse at how fast a news report can move a stock or the entire market up or down. It only takes seconds.

You might be thinking that this kind of volatility is the enemy to your investment portfolio. You may be right but if you are a trader, somebody who holds stocks for a short period of time, you thrive on it. Traders sometimes hold stocks for only a few minutes. They use the market volatility to their advantage by buying a stock when it takes a dramatic swing down and then sell it when it corrects by going higher.

This can make the trader a lot of money but the statistics are stacked against the day trader. The long term gains that day traders make are less than impressive. The only exception are the professionals who are often using tens of millions of dollars per day and some advanced trading techniques to make money.

Investing or Trading?

For the part time investor who isn’t working in the investment field, the best way to make money is to be an investor. Investors are regarded as people who hold stocks for a larger period of time. Often that means years but many investors are now holding their stocks for one year or longer.

One rule that has never changed is the fact that the market rewards patience. For those with a long term approach based on a belief that true wealth happens over time, the stock market, regardless of the 24 hour news cycle, will reward.

Both republicans and democrats seem to be waving flags of surrender and going for the idea of nationalization in droves. According to Republican Lindsey Graham, “We cannot keep pouring good money after bad. If nationalization works, then we should do it.” Ouch.

According to Greenspan, government ownership in the banks would allow the transfer of toxic assets to a bad bank without the problem of how to price them.

Greenspan’s comments came as President Obama signed into law the $787 billion stimulus package and announced another $50 billion in spending for home foreclosure relief.

Regardless of what happens as a result of all the recovery efforts, it’s pretty clear that this will be the defining period of Obama’s presidency.

December Unemployment at 7.2%

December’s jobless rate came in at 7.2%, up 0.4% from November’s 6.8% rate. December’s number marks the highest unemployment rate in nearly 16 years.

November, October Job Losses Revised

November’s job losses were revised to show a 533,000 loss, and October’s numbers were revised to 423,000 from 320,000.

December Job Losses: 524,000

December saw 524,000 jobs lost, bringing the total reduction in U.S. non-farm payrolls in the four months through December to 1.9 million. The services sector got hit the hardest with a staggering 273,000 jobs lost, contributing a great deal to the 524,000 total.

2008 Totals:

Total jobs lost for 2008: 2.6 million. That number represents the largest decline since 1945.

FOMC considers not releasing an explicit target

The minutes show that there was some initial resistance by committee members to slash the Fed Funds rate to such a low level. Certain FOMC members were in favor of not releasing an explicit target rate thinking that would “give banks added flexibility” in determining interest rates. Other members, however, expressed the opinion that such a step would only serve to confuse things.

Historically low rate believed to have more positive effects than negative

According to the minutes, “Most participants judged that the benefits in terms of support for the overall economy of federal funds rates close to, but slightly above, zero probably outweighed the adverse effects.”

FOMC members’ outlook good

From the minutes, it’s clear that, while the members believe the Federal debt, which recently passed the $2 trillion mark, would likely remain at a high level for some time, they have an overall positive outlook on the economy as a whole, stating that recent policy actions leading up to the meeting “should help over time to improve credit conditions and promote a return to moderate economic growth.”

Interestingly, most committee members saw increasing inflation as a generally low risk at this point, while some even went so far as to worry about “uncomfortably low” inflation levels. Committee members suggested quantitative targets for an increasing reserve base could be effective in staving off potential deflation, as well as communicating to the public the Fed’s determination to avoid such a problem.

Potential for deflation?

The members suggested the potential for deflation, which is notably inconsistent with most predictions of coming inflationary pressures on the economy. Unfortunately, the minutes don’t explain the disparity.

Especially considering the Fed recently cut the Fed Funds rate target to 0%, which signals that we’ll almost certainly be facing some serious inflation in the near future as a result. And, as everyone knows, rising inflation equals rising mortgage rates.

You can check out a few of your mortgage options here.

The original plan for the TARP money called for Paulson to use the funds on the purchase of illiquid assets from firms in the financial sector. Paulson’s decision to inject liquidity into the financial system has garnered him a bit of unpopularity and what appears as a bit of a premature request for the second half of the $700 billion certainly doesn’t help.

Paulson’s original plan had been to leave the remaining $250 billion in TARP funds for his successor, Timothy Geithner, but the Bush administration made the decision to hand over $17.4 billion to bailout GM and Chrysler, and the government’s finding it’s pocketbook a bit thin in comparison to it’s recent promises.