What happened was a dramatic fall of the US Dollar against the Japanese Yen, from 135 at the end of the previous week to 117 on Friday 9th. This represents a decrease of approximately 13%. A fall of this magnitude in a single week is certainly dramatic and surprising. But the fact that most of the move occurred over only a single 48 hour period midweek was simply stunning: by Friday it was obvious that currency and bond traders around the world were like deer caught in a car's headlights - not knowing what to do, few were taking positions and trading liquidity in many markets dried up. Bid-ask spreads soared: nobody wanted to take chances (it is hard to place a value on anything in an illiquid market where few or no trades are taking place, so traders err well on the side of caution both on the bid and the ask side).

I was caught off guard by this sudden break in the Dollar as much as anyone else: at the time when the move had already begun in Tokyo I was actually on the telephone with another investor and opining that I couldn't see the USD weakening significantly for the present !

Along with the falling dollar, US Treasuries were hit hard too, after seeing record low yields only on Tuesday (6th October). That was the day the 30-year Long Bond saw an all-time record low of 4.732%. By close of trade on Friday it had reversed to 5.117%. Although these big moves at the long end did result in a significant steepening of the yield curve, the short end was in fact also hit badly: the 2-year T-bill for example which had recorded a low of 3.90% on Tuesday finished trading for the week at 4.20% yield.

Last weeks' mauling of the dollar and T-bills has thus been a very rude awakening. By far the biggest and most important global financial "safe haven" has gone ... poof! ... just like that, in three trading days.

It is worth mentioning that in some ways what happened to T-bills is more telling than what happened to the dollar itself. A sharp increase in yields at a time when inflationary expectations have all but vanished, the economy is slowing, there has been a recent decrease in the Fed funds rate, and further decreases are widely anticipated is not what 'ought' to happen. Some commentators are suggesting that it is due to a reemergence of fears of inflation (triggered by the falling dollar) or that US interest rates may now have to be increased again to protect the currency. But it is not really due to any one specific fear: it simply represents an increase in the risk premium as the currency markets become increasingly volatile and unpredictable, and it is now obvious that the dollar is no longer immune.. To illustrate this, the historical record shows that even during actual deflations when short-term interest rates are plummeting, and are expected to fall further, the yield curve can still be positive with long-term interest rates increasing. This is because risk considerations are outweighing expectations: and a longer time horizon by itself involves increased risk.

This kind of thing also had a negative effect on even high-quality government bonds elsewhere. The bonds issued by major nations such as the United Kingdom and Germany, which had also benefited from some degree of safe haven capital flows, also weakened last week (especially those with longer term maturities), even though their currencies were not under any serious pressure.

Pointer: The bond and currency markets ought to stabilise over the next few days: as the traders get out of those headlights, blink, and start market making again. But I think this should be seen by cautious investors as an opportunity to adjust their portfolios to the new realities. I do not expect the markets to return to business as usual.

At least, that is what I believe: that a severe "bust" is inevitable. The global financial crisis is frequently described as a "contagion" which began in Thailand, spread through Asia, then to Russia, Latin America and other countries, and is now "infecting" North America and Western Europe. Although almost everyone else has been using it, I have avoided using the word "contagion" in The Skeptical InvestorTM like the plague (joke!). It is a very misleading way to describe what is going on. What we are experiencing is not an economic disease that has been spreading from one nation and region to the next since mid-1997. The entire world was already ill long before 1997 - by decades of excessive credit expansion, over investment and dangerous leveraging. The weakest patients have succumbed first. But we will all succumb one by one.

The speed and magnitude of the move together with very strong circumstantial evidence makes forced selling by large highly-leveraged investment funds a much more probable cause. We know now from the public record that several of these entities have suffered huge losses very recently, and we also know without any doubt whatsoever - the US Federal Reserve made no bones about it in the case of Long-Term Capital Management - that they are so big and so highly leveraged that they can threaten the stability of the financial markets. Now, there have been two particular very big sources of cheap money available to these funds (a) the Yen carry-trade, and (b) leased gold. For quite a long time now both have not only provided them with cheap money, they have been very profitable trades in their own right as both the yen and gold have fallen against the dollar.

The Fed lowers US Interest Rates

I think that someone big out there was in trouble. And I have the feeling that it was a major US bank or brokerage, not just another hedge fund. Bear in mind that the US Federal Reserve did not strong-arm the bail-out of LTCM merely in order to save that fund itself: they were concerned about the effects its collapse would have had on the wider economy. And the way that the effects of such a collapse would be transmitted into the wider economy is through financial damage to banks and brokerages. This is the possibility that they are so afraid of. The nightmare of a cascade of losses propagating through the US financial system, and the consequent collapse of credit availability, is certainly now within the realm of possibility.

Over the weekend I have been reading the foreign news media, and it is clear that the view that the Fed's action indicates that there is some sort of immediate problem appears to be quite widely held. However, during the remainder of Thursday's trading session, and continuing on Friday, US stock markets soared, with the DJIA recording one of its biggest weekly point gains on record. The Toronto Stock Exchange joined the party too. The markets thus reacted as though this was just a straightforward interest rate decrease that will be good for business in the usual ways (e.g. by lowering the cost of loans to corporations, and also by stimulating consumer spending on items paid for on credit). Considering that it more likely signals big trouble in the economy, the reaction of the markets looks perverse. I am an investor, not a trader, and make no pretensions to understanding the strategies of market traders, but I suspect that what we saw was more the result of day trading and short-term trading based on the self-reinforcing expectations that an interest rate cut produces a rally. If so, in the absence of further news, I would think it now likely that profits are going to be taken and that the rally will be self-limiting.

Starting from the premise that we are in for a nasty deflationary slump (and I again emphasise that I may be wrong about this), what I would like to start doing in The Skeptical InvestorTM is to now move away from simply monitoring and predicting this approaching storm, and instead begin examining what it might look like from the point of view of investors. I intended to devote this present Issue to this, but events intruded themselves, I suppose that they will do so again, and so I do not know how far and fast I will be able to travel along this road. We shall see.

The whole deflation process is going to be very, very difficult for the investor to understand and analyse. Few people now remember the Great Depression, and since the Second World War all our experience and perceptions have been formed in a long period of inflation. Not just our knowledge and beliefs about economic processes, but those processes themselves have evolved and moulded in a complex integrated adaptation to coping with price inflation. We have the historical record of past deflations to help, but that will only offer us a little guidance. We are sliding into this event in a world in which there is not a single gold-backed currency: no anchor of value anywhere. (A month ago I would perhaps at this point have needed to explain why the "good as gold" US Dollar is not such an anchor. But not now!). Events will unfold in surprising, unpredictable, often counter-intuitive ways. All we can hope to do is explore some of the possibilities a little bit.

This is what I meant in Part A when I said:-

"The idea (at least in its simplistic form) that in times like these 'cash is king' is a leftover from the days when currencies were backed by gold and silver."

What are the implications? Well, for reasons that are quite well-known (and I will discuss when I get to look at other asset classes) during a deflation investors seek safety of their capital by moving into cash and cash-equivalents such as short-term government bonds. The yields on such instruments will fall relative to yields on riskier financial instruments, leading to widening yield spreads, and will normally fall in absolute terms too. But, given that currencies themselves are now risky investments, the investor will expect a return on investment that will compensate him for that risk. This will tend to drive up the deposit interest rate needed to attract him, and incidentally make the holding of hard cash under the mattress less attractive than it otherwise ought to be.

But then consider how central banks will adjust interest rate policy. In recent history, we have become used to high interest rates being used as a tool to smother inflation, but deflation is a very different animal. Lower interest rates are widely used in an attempt to stimulate the economy (probably unsuccessfully - as in Japan since 1990 - but that is another story. The point is that CBs will attempt to end deflation by lowering rates).

See the problem? As the world economy slides downhill, it experiences increasing instability and volatility as it adjusts. Forex rates become unstable: we saw just how unstable in the early stages of the crisis last year - to the extent that what was then happening in Asia was widely misinterpreted as a currency crisis. And we have seen it again recently in the USD and the Yen. But one of the tools most likely to be used by governments and CBs to try to arrest the process, lower interest rates, will make the problem even worse. Indeed, as deposit interest rates and yields on government bonds and notes approach zero, holding them becomes more and more nothing but a currency play. In their attempt to reduce currency risk, in an environment where offered yields are too low to compensate them for it, investors will be pushed into moving from currency to currency. Volatility will increase further, hence even more currency exposure risk. A vicious cycle.

The most straightforward way for the personal investor to deal with this is by diversification. In a world of free-floating exchange rates, all currencies are merely moving up and down relative to each other so a sensibly selected basket of different currencies ought to be a good defence against loss of capital (unless there is a total collapse of the global financial system).

In deflation, if you can retain your capital intact, its purchasing power will increase due to the collapse of asset prices. Thus that ought to be the core strategy of the conservative investor who wishes to position himself for deflation. A properly diversified 'safety' portfolio of shorter-maturity high-quality government bonds and cash deposits held in several different major currencies ought to do the trick. Gold and other precious metals have also traditionally been used to hedge portfolio risk, and although PMs have been awful investments for a long time now, the kind of currency gyrations that I see as being possible may in due course drive investors back into them. Indeed, the behaviour of the price of gold during recent bouts of market instability suggests that this may be starting to happen already. If it returns to its traditional role as a store of value, gold can be just as attractive a holding during deflation as during severe inflation. I currently hold approximately 5% of my own 'safety' portfolio in PM-related investments for exactly this purpose as a hedge, and may gradually increase this to 10% if it appears sensible to do so.

The above is of course not intended as investment advice to anyone, but, as always, merely as food for thought. A portfolio constructed in this way won't do very well if we get inflation, but it is very liquid and so can be adjusted quickly if needs be. And you can always choose to hold short-term bonds to maturity, so incurring only opportunity costs rather than capital losses if interest rates turn up. Anyway, it is something to think about.