Avoid U.S. Dollar Based Stocks and Bonds

Among the many curious facts about today's markets is this - the U.S. dollar has gone down sharply, but bonds have remained strong.

People who lend in dollars get repaid in dollars. An obvious consequence of a falling dollar is that lenders have to expect to get less back than they originally invested. In the last few weeks, the dollar has lost about 4% against the Aussie and 5% against the euro. Yet, the 91-day T-bill lending rate is only about 4.90%. Go figure. Lenders expected only 4.9% on their money - for a full year. And in a few weeks, they've lost more than that, in international terms. What's more, they still have to pay taxes on the nominal gains...and still have to suffer the effects of domestic dollar inflation.

What are they thinking? Are they thinking at all?

Currency fluctuations come and go, of course. But so do currencies themselves. Yet bond investors seem to be betting that the dollar is eternal; and they find themselves trapped between two paradoxical trends. On the one hand, the U.S. economy is deteriorating.

The inevitable effects of weakness in the housing sector are working their way through the entire economy...like termites through soft wood. Sales are going down; prices are falling; inventories are rising. Fewer people are being hired to pound nails, or grind down granite for kitchen countertops. Fewer people are taking up careers in real estate. And the feds are nosing around a sub-prime mortgage industry; if they want to be ready with some show trials when the business blows up.

Manufacturing is going down too, unexpectedly. Petrol prices are going up. And Wal-Mart tells us that consumers are not reaching into their pockets with the same sans souci as they once did.

This economic weakness could be expected to lead to lower bond yields - which would mean higher bond prices. Bernanke and Paulson are talking about fighting inflation - suggesting that that the Fed might raise rates. Our guess is that they are just talking, in order to try to hold up the dollar. The real danger for the U.S. economy is not that it is likely to ‘overheat' and need higher rates to fight inflation. The real danger is that it is likely to cool off...and ice over. The Fed is not likely to risk raising rates with so many people trying to sell so many houses. It is more likely that they will cut them - which would cause bonds to go up.

On the other hand, the foreign currency markets are telling us that the U.S. dollar is vulnerable. It could be re-rated at a level considerably lower than it is today. Currently, it takes $1.32 to buy a euro. It could easily take $1.50. Likewise, the price of gold is $650. It could just as well be $750. Either way, a bond investor has to start asking himself questions: ‘what if I'm right about the economy, but the dollar still loses another 10% on the foreign currency markets?'

And now imagine that you are in charge of your country's foreign currency reserves...in China, Russia, or Japan. Yes, you can put your money in 30-year U.S. government bonds, guaranteed by the world's only superpower and denominated in the world's reserve currency. No one will fault you; it seems like the prudent thing to do. After all, Americans are your best customers. Buying U.S. government bonds is, effectively, lending to your customers. That way, they'll have the money to continue buying your stuff.

But wait...what if the dollar does go to $1.50 per euro? Imagine that you have $500,000,000,000 in your vault. That would be a loss of about $75 billion. Wouldn't it make sense to hedge it a little? Reduce your dollar holdings $400,000,000,000 - at least?

As the dollar falls, it makes more and more sense for investors to hedge against it - especially foreign central banks. And when they turn their backs on the dollar, it puts the whole ‘new imperial cycle' in jeopardy.

Here at The Daily Reckoning, we have been as perplexed as bond investors. We saw the weakness in the U.S. economy...we guessed that it would be good for bonds...and yet, we have been reluctant to buy bonds, because it seemed to us that yields were too low to justify the risks - the stability of the U.S. dollar being the major one.

What to do? Our advice it to hedge against the dollar - by buying gold or foreign currencies - and to avoid U.S. dollar-based stocks and bonds until they offer good value again.

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