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Don't Get Blindsided: Adjust Your Dollar Offense, Defense

By Sean Hyman   |   Monday, 05 Apr 2010 04:46 PM

This past week was a strong one for the financial markets. The Dow, Nasdaq and S&P 500 all finished at, or near, 52-week highs.

Several commodities have done the same. Oil, copper and gasoline futures all finished the week at, or near, 52-week highs as well.

So for right now, the offensive players are still on the field.

Which currencies are on the offensive team? They are the Australian dollar, New Zealand dollar and the Canadian dollar for sure. The pound and euro are third stringers, at best.

The commodity currencies are the first-string players because they will deal the best with inflation since they are the commodity-exporting nations. They will also tend to have the most aggressive central banks as inflation starts to rise.

So far, Australia has been the only one of these central banks that has been pre-emptive and has taken action ahead of time.

However, if the financial markets continue to move up in the near to medium term, then we'll likely see the New Zealand and Canadian central banks step up and start to hike interest rates sooner rather than later.

When rate-hike cycles start, it tends to be very supportive of a currency, much like strong earnings reports help to support a stock's price.

The biggest of currency investors are "yield seekers." They come out in droves when the financial markets are sideways to upward trending. They only tend to run for cover when they think the bottom is about to fall out or a downtrend is in force in the financial markets.

It also helps that the Volatility Index (also referred to as the "fear gauge") is downward trending as well. So when the volatility in the stock market is low, currency investors are braver and they are more willing to dive into higher yielding currencies like the Aussie dollar.

So with improving U.S. employment numbers and unemployment numbers that are off of their worst levels, the offensive players will remain on the field.

However, the pros know when to remain cautious and when to put their defensive players out on the field.

For instance, I'll be watching as the Federal Reserve and other central banks start to remove the stimulus measures for these economies (as they stop purchasing mortgage-backed securities and other assets).

We'll get a better picture then if the consumer starts to pick up the slack as these central bankers ease out.

If the economic numbers start to soften up afterward, then these central banks have pulled out too early and the consumers in their nations haven't taken up the slack.

If that's the case, there runs a huge change of a double-dip recession.

Even if these central banks have to run back in and "save the day" again, the sentiment will be very bad because investors will realize that the markets are only holding up as the governments are intervening and keeping the markets propped up.

If this scenario plays out, look out below!

Also know that if this happens, you'd better have your defensive currency team in place as stocks fall.

Either way, the currency investor always has a great play.

When the financial markets are stable and volatility is low, then these commodity currencies will hold up quite well. If financial markets start to cave in, we can just as easily switch gears into the more-defensive currencies.

They will rise as stocks plummet and therefore those investors that also have the exposure to currencies won't take it on the chin like stock investors will.

They will have a hedge that prospers as their stock portfolios pare back.

They will make out far better because of the wisdom of diversification into currencies.

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