A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold

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Imagine a sovereign debt crisis being bullish for the U.S. dollar and bearish for gold. In fact you don’t have to imagine it all. Or be insane. Bloomberg reports that, “Dollar Rises as Stocks, Commodities Fall in Flight From Risk.”

February gold futures fell below $1,100, down 2.5%. The Dow Jones Industrials fell 1.27%. The S&P 500 shed just over 1%. And the U.S. dollar rallied against all 16 currencies in the dollar index. What gives? First a chart.

US Dollar Index

Above is a three-year chart for the U.S. dollar index. We don’t use charts with quite the same precision as Murray. But we did put three boxes around clusters of trading activity where the dollar index broke above or below the high 70s level.

For whatever reason, this is both resistance and support for the index. Right now, if the index can get above and 78 and hold it, you’d reckon the long-awaited U.S. dollar rally is here and it’s going to do some damage to risk assets, including Australian stocks and the Aussie dollar.

This is a point Bill made when we visited him in South Africa last week. He said, “Stocks will go lower and gold will go higher, but the bear works in mysterious ways. The bear shakes out those with weak conviction. They are suckered in by rising prices and beaten down by corrections.” The dollar is suckering in more suckers.

Still, it’s strange to see the dollar rallying on risk aversion, as if the dollar itself wasn’t the greatest risk of all. The U.S. Congress raised America’s debt ceiling by $290 billion this week to $12.394 trillion and passed another $154 “jobs bill” (which shows you how effective the first one was).

These aren’t the sort of things that make a currency stronger. As our friend Jim Davidson said when we visited him in New Zealand recently, “I can’t think of a single example of a country that became great or stayed great because of all the money it owed.”

It’s hard to argue with that. In fact, we’ve argued before that the global financial crisis has morphed into a sovereign debt crisis. 2010 will be full of nation states discovering their funding model is broken. Yesterday, for example, ratings agency Standard and Poor’s cut Greece’s credit rating A-minus to BBB-plus. That is not an improvement.

The euro and the British pound and gold and nearly everything else fell against the greenback. But we would view these unusual periods of dollar strength as chances to build your position in alternative investments at a lower average purchase price. Buy gold stocks when they correct and add to your gold position at lower prices. The dollar rally won’t last forever.

In fact, “When the U.S. has to fund its deficit through the combination of issuing more Treasuries and printing more dollars, it is inevitable that the dollar will continue to weaken,” said Zhu Min the Deputy Governor of China’s Central Bank. He’s a man who’d have a lot of interest in the value of the dollar. China owns $798.9 billion in U.S. Treasuries.

Here in Australia the ASX/200 is following Wall Street’s lead. But outside the market in the real economy, the energy deals keep humming along. Japan’s Chubu Electric signed a $30 billion sales agreement with the Gorgon LNG project in WA, according to Matt Chambers in today’s Australian. Chubu – in addition to gas for its electricity power plants in Japan – gets a small equity stake in Gorgon.

Gorgon is a conventional LNG project. Queensland has more of the “unconventional” gas. But those projects are hopping along too. Dow Jones newswires reported yesterday that “a person familiar with the situation” says Tokyo Gas would buy coal-seam-gas from Queensland’s emerging LNG district, “If prices were low enough.”

This is another example of substitution. “Japan uses mostly rich LNG now, and many utilities, including Tokyo Electric Power Co. (9501.TO), have said they aren’t interested in coal seam gas LNG, citing technical difficulty in handling lean LNG together with conventional LNG… But sellers of coal seam gas LNG understand these inconveniences for users and are offering competitive prices.”

Does that make coal-seam-gas the poor man’s LNG? Who knows? But we do know that Kris Sayce took profits on several Queensland LNG shares this year. The shares went up before any of the companies ever produced gas. It might seem strange. But not really.

When projects get “de-risked”, the more advanced they get. There are several factors involved: the quality of the resource and how ‘proved up’ it is (i.e. how much of it can economically produced at a given underlying commodity price). Then you have a company’s capital structure and financing plan. Then there are labour costs, government and environmental permitting, off-take agreements, cap ex over runs, and operating expenses.

For the smaller emerging players in this space, the share prices tend to rise as these factors move from the unknown to the known category. Or, in some cases, the share prices do not advance if something that’s newly known is bad. That’s why the stock market is not a savings account. There is always a risk of failure.

That said, this incipient dollar rally might take the heat out of a lot of those Aussie resource shares that did the best in 2009: small cap resource and energy shares. That’s why both Kris and Alex Cowie have been using trailing stops to exit positions as the market moves down, mostly at a profit but sometimes to minimise a loss.

Even if you’re not a subscriber to either of those publications it’s a useful idea. When capital flows are so volatile – and they’re going to be in a world with sovereign default risk – you can get sudden swings in stock markets that may not seem related to underlying company fundamentals. But that’s the financial world we live in (thanks Time man of the year!)

Don’t be a hero and go down with the ship. Preserve your capital and live to fight another day, perhaps in the same shares. That may seem more like a trader’s strategy. But a world of low short-term interest rates and easy money forces you to shorten your time horizon and more actively manage your assets – or risk getting eaten alive by inflation and/or shifts in asset and currency markets.

That probably sounds more complex than it is, though. Lock in profits. Don’t take big losses. Be disciplined. And focus on the underlying trends that should drive earnings growth in specific sectors. If you do that, you’ll at least know where to look in 2010 when the dollar rally ends and secular trend in tangible assets resumes. Until then…

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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