For example, oil ought to be heading lower - or at least not higher - as the U.S. dollar rallies. But news reports out of Iraq this weekend showed that some Iranians had taken control of an Iraqi oil field. It didn't look like anything serious, to be honest. But it shows you what a hair trigger there is for oil.

On a totally domestic note, Bloomberg is reporting that Westpac raised $2 billion selling residential mortgage backed securities last week. It's notable because it's the first time one of the big four has managed to sell a batch of RMBS since the financial model of the world began to fail in 2007. So have things finally turned the corner for funding Aussie mortgage growth through securitization?

It's probably too early to say. The Australian Office of Financial Management continues to support the market for non-bank lenders. Non-bank lenders have to fund new loans via securtisation. Without the AOFM's backing, you have to wonder how many first home buyers would have been able to find housing finance.

Of course, when you take a closer look at the institutions which sold RMBS to the AOFM, you find that some of them are simply off-balance sheet vehicles for the Big Four. These used to be called Special Investment Vehicles before they got a bad name. They allowed backs to make high-risk loans without doing it on the balance sheet of the parent company.

Same day. Different mortgage bubble.

Gold reversed its big slide earlier in the week and closed higher along with the greenback. February gold futures on Comex closed up $4.50 to $1,111.50. That's neither here nor there. But it does tend to confuse the popular press, who like to report that gold rises when the dollar falls and falls when the dollar rises.

That used to be true a few years ago. But since then, gold seems to have "decoupled" from the dollar on the downside. That is, there are enough different sources of gold demand that it doesn't automatically fall when the dollar rises. Not that it matters too much, mind you. The dollar IS generally going to get weaker, and gold stronger. Lots of noise in the interim though.

The wires are reporting that 60 U.S. Senators have now lined up behind a health care bill. It's not the same bill that passed the house. Those two bills have to be "reconciled" in a conference between both bodies before final legislation can be voted on by each house and sent to President Obama for approval.

In other words, there's a long way to go yet. But it will be worth watching to see how the market reacts. The U.S. government is adding to its long-term liabilities just when it ought to be reducing them. And absurdly, Obama is presenting the health care plan as a way to reduce the country's long-term deficits.

How you reduce deficits by adding more coverage, which will push up costs, is beyond us. It's beyond most people, in fact. That's why the healthcare bill is polling badly lately. But what will the market think of the Feds making more promises which must be kept by borrowing more money?

Stay tuned!

We quoted comments from Chinese central banker Zhu Min last week about how the current situation isn't stable. Zhu was at it again this week. "The United States cannot force foreign governments to increase their holdings of Treasuries," Zhu said, according to the Shanghai Daily.

U.S. officials are hoping they can keep piling up the bills and selling debt to foreign governments and bond buyers who will simply increase their holdings of US debt. Zhu says not! "Double the holdings? It is definitely impossible."

"The US current account deficit is falling as residents' savings increase, so its trade turnover is falling, which means the US is supplying fewer dollars to the rest of the world... The world does not have so much money to buy more US Treasuries."

The Fed can always make more money. But the secret is out on this little trick of quantitative easing. The thing is, central banks in the Western world (including Japan) may have to resort to even more QE to pay the bills in the coming years. This will provoke what we've been talking about: a sovereign debt crisis.

But you wouldn't guess any of that from the Christmas spirit here at the airport. Paper money from all over the world is changing hands like it's actually worth something. And it is. It's just less and less by the moment. We'll report back from sunny Colorado when we get there in about 18 hours. Until then!

Dan Denning
for The Daily Reckoning Australia

• A National Mortgage Bubble
• Negative Equity Becoming the Norm in U.S.A.
• RBA Buys $780 Million in Residential Mortgage-Backed Securities
• Consumer Economy Not Going to Return to Robust Growth Anytime Soon
• Mortgage Backed Securities Put Our Financial System at Risk

The context for this week's action was a strange day on Wall Street on Friday. The U.S. dollar, at long last, rallied a bit. It scared the daylights out of everyone. The Dow and oil fell. Bond yields rose. But gold went up on Friday and finished the week up 2.7% to $1,146.80. That's right. Gold rallied with the dollar. Hmmn.

Days like Friday make investors question their conviction. They start to convince themselves that after a near 60% rally in stocks since the March lows, some kind of correction is coming. But they wonder if it's just a run-of-the-mill correction. Or is it phase two of the Depression that began in 2008?

Our focus today, though, is on the bond scam being perpetrated by money-grubbing governments. That is, our focus is on the counter-attack by national governments against rising bond yields. Between the GFC and ageing populations, the Western Welfare States know that they must increase deficit spending in the coming years. But already the gold market is telling them what global savers think of this (not much).

So how does a government fund its spending programs if global creditors begin to turn to other assets? Well, it can have its own central bank "monetise the debt." But having the central bank buy government bonds with new money is a sure-fire path to currency depreciation and higher interest rates. It simply highlights what we've been saying for five years now: the funding model for the fiscal welfare states is broken.

But lately we see that we've underestimated just how clever governments can be at squeezing new revenues out of people and forcing the market to choke down government bonds. Last month, the FT's Alphaville blog reported that the U.K.'s Financial Services Authority (FSA) is essentially guaranteeing a bond bubble by forcing banks to own sovereign bonds.

The FSA is doing this for the banks' own good, of course. With liquid government bonds on the balance sheet, the banks would have a "liquidity buffer." This should, the FSA reckons, inspire faith by market participants in the fundamental health of the banks, and prevent another collapse of public faith. Ahem.

But did you know in a September discussion paper called "APRA's prudential approach to ADI liquidity risk" that the regulator of Aussie banks is considering imposing a similar liquidity requirement on Aussie banks? It would force the banks to own assets of a certain credit calibre. And you can guess which assets would qualify.

Go on. Guess. We dare you.

Really, you can't make this stuff up. Western governments are starting to tell Western banks that the only way for banks to be sure they have sufficient liquid assets is to buy more government bonds!

And it won't be a choice. The banks should have known better than to take government money and government guarantees. It was only a matter of time before governments came up with a way to tap bank deposits to pay for massive borrowing programs.

APRA says its current policy regarding liquidity at banks, "provides little guidance as to what constitutes a liquid asset for stress-testing purposes." However, the Big Con begins, "there is an emerging international consensus amongst prudential supervisors that liquid assets should be high quality assets that can be readily sold or used as collateral in private markets, even when those markets may be under stress; as a backstop, liquid assets should also be eligible central bank collateral for normal market operations."

Here's where the intentions are laid bare. "APRA proposes to adopt this definition of liquid assets in APS 210. In most currencies, sovereign bonds will be the assets that most clearly satisfy these criteria."

APRA then expressed some mock concern that because Australia's Federal government had consistently run surpluses for the last ten years or so, it would have to work with the Reserve Bank to find some other "safe" asset like a sovereign government bond for banks to involuntarily load up on. But that was a bit rich.

After all, the Australian Federal government is piling up the debt! The Australian Office of Financial Management is selling $2.4 billion in bonds and notes this week alone. Choke on that, the Big Four. Granted, the AOFM says Australia's 2010 borrowing program of $50 billion is slightly less than Treasury expected, given Australia's improved GDP picture. But it's still a lot of debt to sell.

Of course if you're forcing banks to buy it, the sale is not as hard. Maybe we are getting ahead of ourselves, though. APRA says it won't impose the new liquidity requirements until next year, after it's had time to review responses to the idea from market participants. Right.

Incidentally, did you see that both the Commonwealth Bank and Westpac fell back on the government guarantee to raise money in the wholesale funds market last week? CBA tapped the guarantee to raise $1.36 billion in the U.S. market. Westpac, on the other hand, tapped the guarantee to raise money right here in Australia. It sold $1.1 billion worth of bonds, and apparently the local market was a little tepid without the government guarantee.

Unless the banks are using the government guarantee to borrow money which they can invest in some higher-yielding asset, you know it's not something they want to do. It costs them more to "rent" the Aussie government's AAA credit rating. And it's not something they've had to do in three months. What does that tell you?

It tells us that when you're a net capital importer, your banking system is not nearly as healthy and robust as you think. Borrowed booms are fickle.

But it's not like the Aussie Federal government or the State governments are a picture of financial health either. In today's Australian Scott Murdoch reports that, "The debt of Australia's six state governments could soon outrank the $136 billion owed by the commonwealth as the state administrations fund an ambitious infrastructure program in a bid to boost the economy.

Murdoch says state governments will float $28 billion in new debt in the next seven months, prompting us to wonder which Aussie state is the most like California, fiscally speaking of course. Queensland appears to take the cake, with a $57 billion annual deficit and projections for eight more years of deficits. New South Wales comes in second.

Yet the Keynesians, if we ever gave them breathing room in this space, might tell you that funding long-term infrastructure projects with government debt is exactly the right thing to do in a recession. The government spending makes up for shortfalls in private sector spending. And when the recession passes by, the entire state (and nation) are left with shiny new infrastructure that increases export capacity and productivity. A win win!

Maybe it will work that way. And maybe it won't. The really interesting scenario is whether state government borrowing needs begin to compete with Federal borrowing needs. The Feds can compel Aussie banks to buy government bonds, if the APRA rule passes. What can the States do to make sure their debt is purchased? Hmm. A government guarantee? Chocolates and flowers to creditors? A pretty please?

A government's inability to pay for the promises it's made is no laughing matter, especially when those promises involve an ageing population. But, "The commonwealth budget is in danger of going directly from the deficit caused by the financial crisis to one caused by ageing of the population without ever seeing a surplus," writes David Uren in today's Australian.

It would be a bitter pill to swallow. After all, Kevin Rudd has promised that strict government spending limits will put the Federal budget back into surplus sometime around 2015-2016. Ahem. But it's now looking like the deficit that was born under the GFC will grow and flourish as Australia faces the same demographic crisis as other Western nations: paying for the retirement and healthcare of the Boomers.

But wait! The IMF says that by 2014, Australia's public sector debt as a percentage of GDP will be just 27.8%. That's not worrying at all, is it? Especially when you compare it to projected levels of 108% in the U.S., 98% in Britain, 128% in Italy, and a whopping 245% in Japan.

Those countries have real problems. American and Britain have broken financial systems and massive public sector debts that are still growing. Japan and Italy are getting old, with fewer workers to support retirees. Will those governments be able to borrow what they need? Or will the bond market rebel?

You'd think Australia wouldn't have much to worry about, compared to that quartet. But remember: the country is a new importer of capital. The government, like the private sector, has to borrow from foreign creditors. And foreign creditors have to want to lend Australia money. So will they?

They might, perhaps at higher interest rates. But then again, maybe they'll just come for Australia's oil and gas and its oil and gas companies. A recent report by Deloitte previewed a coming contest between independent oil companies (IOCs) and national oil companies (NOCs) owned by governments. "Over the next couple of years, IOCs will start to be faced with the dilemma of constrained access due to ongoing resource nationalisation and the growing sophistication of the NOCs."

The NOCs believe in free markets, except when it comes to maximising the value of strategic resources like oil. They do, however, like to use free markets to pursue acquisitions in foreign equity markets. "National Oil Companies (NOCs) are on the hunt," the report says.

"The are aggressively looking for corporate M&A opportunities to accomplish their three goals: bolster their market strategies; expand their reserve portfolios; and develop strategic alliances...From an economic standpoint, net consuming NOCs are seeking to gain access to sufficient reserves to fuel their countries' economic engines over the long haul."

The NOCs can meet some of their needs by making deals with each other. Evidence deals between China and Russia, China and Brazil, and China and Kazakhstan. Do you notice a pattern here?

The other method the NOCs might take is to pursue listed independent oil and gas juniors who are rich on exploration projects but capital poor. There are a few of them here in Australia. It's not a bad trade.

Deloitte writes that, "Independent oil and gas junior companies have struggled in recent months due to their higher sensitivity to oil prices and tax regime changes. After the oil price collapse of 2008, many leapt into survival mode.

"Those that succeeded in freeing up cash are now poised to implement M&A strategies designed to enhance their reserve portfolios while those that remain cash strapped, which is still the fast majority, are likely to be M&A targets."

There's an idea for investors. Don't go after the cash-rich juniors. Go after the cash-poor ones that are likely to be M&A targets and might get a bit of a premium bid from potential NOC acquirers. Hmm. We'll ask Diggers and Drillers editor Alex Cowie what he thinks of the idea and get back to you.

In the meantime, if you want a more comic perspective on China's choices in the coming years, have a look at this skit. And then ask yourself how easy it's going to be for borrowing nations to get what they ask for with no strings in the future. For Australia, you have to wonder what the strings are going to be. It depends on who's doing the lending.

If it's European and U.S. banks, the "strings" will be higher interest rates. If it's China, the "strings" might be a friendlier and more transparent policy from the Foreign Investment Review Board concerning Chinese acquisitions of Aussie companies. And if the Reserve Bank has to eventually monetise Aussie debt, the "strings" will be much higher inflation.

Dan Denning
for The Daily Reckoning Australia

• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• Inflation is Evident If You Just Follow the Money
• One Year Treasury Bills to be Reissued by Bush Administration
• What Kind of Investor is Happy to Lose Money Over 90 Days?
• Is the American Government the Place to Park Your Money During Dangerous Times?

"Okay."

"Why so serious? I mean, all you do every day is write about the worst-case scenario. It's depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?"

"Is that code for, 'buy me another beer?'"

"No, seriously. It's not all bad all the time is it?"

We'll tell you how we answered our friend's question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq - the ones enjoying a bit of euphoria renaissance - were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.

Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia's great policymaking and unique relationship to the China boom.

But the alternative tune - the one which we've been humming - is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.

That's just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.

It doesn't have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that's the one we're offering you. Beware carry trades promising false permanent prosperity!

But what about today's earnings? ANZ followed up yesterday's bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the "bad debt cycle" is over and that things can only get better.

Let's take the other side of that trade. Again we'll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).

What does that mean? It means the company is making plenty of new loans (you'd want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.

Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you're vulnerable if that capital is not forthcoming. It's great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.

It's not just us saying this, by the way. "We need to figure out how we can become less dependent on wholesale funding to finance our economic growth," said Commonwealth Bank of Australia chairman John Schubert in last Friday's Australian Financial Review. "It is not assured that we will get the funding into the future."

No foreign funding, no continued housing boom. In fact, we'd be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it's done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.

The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.

But let's assume for now the public sector does not enlarge again to Depression-era levels of debt. Let's assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it's fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.

That's not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.

A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can't pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they've concluded that most of the banks' assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).

And maybe they are right. But we're just saying...in a world dominated by massive credit write downs...where we have just seen six months of re-leveraging...and where house values here in Australia have managed (thus far) to escape massive deflation...is a six percent loss on assets totally unimaginable?

We can imagine it, although we don't relish it. Either way, we wouldn't buy the banks just now.

But if you're looking for the most over-valued asset class in the world - the one worth a punt for going short - it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the "only attractive bet" going at the moment.

"I always like to think about assets that are likely to experience a breakdown; the only thing I'm pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities...I think that those are overpriced so they are attractive shorts."

If you're not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.

For a trader - other than cash and gold - we'd look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound - although they will be fighting the general trend in the market. We'll ask Murray what he thinks and get back to you.

So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?

"Relax dude. It's my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work."

"Huh?"

"My work isn't negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you've got the big picture sorted out correctly."

"But you make it sound like the end of the world every day."

"It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world...Besides, it's a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage."

"But how can you be so sure you're right about the big picture? Everyone else I talk to says there's no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?"

"Certified. But that doesn't mean I'm wrong. You can't keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you've borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it's in addition to a huge amount of money they've already borrowed. It's the end-game for the whole financial/fiscal/political model."

"But so what? Isn't everyone else doing the same thing?"

"Well yeah. All fiat money is a scam. It's a way for the government to run perpetual debts and steal savings through inflation. It's an immoral living arrangement in that respect. But more importantly, from a financial perspective, it's a way of funding a political arrangement. And that way of funding it - borrowing more and raising taxes on a small productive class to pay for a larger public sector - is every bit as dead as the funding model for investment banks."

"But the government bailed out the investment banks. Who is going to bail out the government?"

"No one. Nothing. It will try inflation. But that doesn't work. Printing more money to pay off your debts just destroys wealth. That's where we're headed. That's what you should plan for. Sooner, not later."

"I would like to begin my plan with another beer, if it's all the same to you."

"No worries."

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…
• A National Mortgage Bubble
• Fed Now the Middle Man in Interbank Lending Market
• Borrowing and Paying Back in a Foreign Currency

Which shares win and which shares lose the stronger the Aussie dollar gets? Slipstream Trader Murray Dawes has been on the case over the last week, looking for other tradeable trends in the ASX 200. The stronger Aussie affects the costs and export earnings of big domestic companies. That makes it a catalyst for trading ideas. And the size of the moves in these larger capitalisation stocks is kind of surprising. But for it to be profitable, you have to first sort out who wins and who loses.

GoldmanSachs had a crack at it last week. According to today's Australian, "The biggest winners include Qantas and Virgin Blue (lower fuel costs and strengthening outbound travel), Boral (lower offshore debt costs), condom and glove maker Ansell, apparel importer Pacific Brands, diversified industrial Alesco and waste manager and car importer Transpacific."

And the possible losers? The report says they will be, "Defensive stocks with an offshore earnings skew and which also are not exposed to this global growth. These include CSL, Cochlear, Resmed, Ramsay Healthcare and QBE Insurances. GSJBW cites BlueScope, Paperlinx, Caltex, Incitec Pivot and Aristocrat Leisure as other losers, but notes currency is only one of many variables affecting earnings."

We reckon it's all a bit of tempest in a tea cup. Corporate earnings have been inflated by the credit bubble and funny accounting for the last 50 years. A quarter or two of noise about earnings is not the big story, even if the currency move is substantial. There are really only two questions that matter.

The first is whether or not shares as an asset class are a good idea right now. That's a huge debate. But part of the answer lies in your views on inflation. As we argued here in July, stocks are definitely better than bonds when inflation is the big threat. The Reserve Bank seems to think that is the case. So make of it what you will.

What we make of it is that dividends used to account for a much larger percentage of your total return in stocks than they have in the last twenty years. Times change. There's no rule that says the future has to be just like the past. But if stocks beat inflation, should you invest in stocks for income or capital appreciation? That's the second question.

Aussie investors haven't usually had to make that choice. Bank stocks, for example, provide dividends and capital growth. But today, we reckon that cash flows are reverting back to the mean growth rate, which is obviously lower in a world that's deleveraging and relying less on credit to fuel business and consumer spending. Rather than being inflated by consumer demand (supported by credit) we predict slower rates of organic growth, across the board. This rewards investors who pay attention to how a company generates its earnings.

Kris Sayce in his work at the Australian Wealth Gameplan, reckons that now is a good time to add dividends to the mix to beat both inflation and the trend toward smaller growth in corporate cash flows. Practically, this means investing in businesses than can increase earnings in good times and bad and can do so without high capital costs which force them to borrow money. They return the excess cash to shareholders.

In cash flow growth is constrained by less credit in the system, you also want to own businesses with leverage to a rising commodity or an emerging market. This works out pretty well for a lot of Aussie firms.

Take energy. Chevron announced another major gas find off the coast of Western Australia this weekend. Chevron's $21 billion investment in the Gorgon project in WA is already the company's single-largest investment anywhere in the world, according to the Australian Financial Review.

And why? Chevron reckons LNG from WA is going to be the carbon dioxide friendly fuel for Asia's future. True, the fixed capital costs for producing off-shore LNG are high. But the whole industry is certainly leveraged to higher energy prices, which ought to translate into higher earnings for Chevron. Your risk is that oil prices crash and take LNG prices with them, upsetting the whole applecart.

So how does this all fit into an investment strategy for a world where there is no clear winner between inflation and deflation, where there is still massive leverage in the financial system, and where public finance is creating huge long-term deficits to replace (mistakenly) the missing demand from households that are beginning to live beneath their means? Good question!

You can trade the blue-chips in their ranges based on currency exposure or leverage to commodity prices. This is what Murray is up to at Slipstream. Or you can just chuck a few market-tracking ETFs in your portfolio and forget about it, in which case you can read the DR for fun and laughs rather than investment ideas. But you can also afford to be a bit more selective, and should probably consider doing just that. Why?

If the Credit Depression is going to take a bite out of corporate cash flows for years to come, focus on that risk and avoid the stocks most vulnerable to it (leveraged players in property, mortgage lenders, and banks.) But also build yourself, as Nassim Taleb says, a portfolio of risk's that's built for a world of extremes (Extremistan!).

Taleb says you want a maximum amount of zero-risk securities. Whether that is cash, bonds, dividend-paying stocks, property, or gold bullion (not really a security) is where the debate lies. He also recommends, though, that you have a small amount of risk capital in maximum risk securities. Which ones?

You want securities where you'll find low-probability but high-value events that can move the share price. This is not banking. In banking, all the low-probability (or frequency) events tend to have catastrophic consequences when they do occur. Russia defaults. The subprime market blows up. You have maximum risk. The probability is remote, but the magnitude of an occurrence is a portfolio destroyer.

But in other areas - small cap stocks, oil and precious metals exploration and production companies, for example - the low probability events are almost always high magnitude events in a positive way. You cure baldness or impotence. You find gold or oil. You invent the iPod or Google.

In these businesses, cash flows and earnings are above trend for a three to four year period in which the share price trades at a steep premium, factoring in future growth. This is the sweetest of sweet spots for growth investors. But to taste it, you have to also have a taste for risk.

That's why it's worth being in the market in a small amount of low-probability but high-magnitude type companies. You want a portfolio of risks like that. And it doesn't have to be a big one to be worth it, or jeopardise an otherwise risk-averse strategy. In fact, we reckon that this strategy is going to generate far better returns over the next ten years that the conventional buy-and-hold blue chips through your super strategy.

Dan Denning
for The Daily Reckoning Australia

• Note to Australia: Buy Resources, Not Banks
• The Problem With a Well-Diversified Portfolio
• Gone Fishin’ Investment Strategy
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Inflation is a Reality in China

Energy is a great long-term investment theme. As we've mentioned before, the collapse in capital spending in 2008 almost guaranteed that any resumption in demand growth would trigger higher prices because of much lower supply growth. Everyone's been focused on inventories and the global recession. But it's supply that you should keep your eye on.

Of course Goldman is just talking its own book. Everyone is talking his own book, come to think of it. But in this case, we like the book. And more importantly, we think a carefully selected portfolio of energy shares (conventional, unconventional, and alternative) is big part of making money as an investor over the next five years.

Switching gears, did you see what RBA governor Glenn Stevens said yesterday? He said the RBA would be willing to cut rates again if it needed to. But he also said, "It would be counterproductive, though, if further reductions in interest rates induced a large number of marginal borrowers into debts they could service only at unusually low interest rates."

Wow. What's gotten into these central bankers lately? First Ben Bernanke puts on his serious face and tells the U.S. Congress that large deficits threaten financial stability. And now we have Mr. Stevens pointing out the dirty little secret of lower rates. They encourage debt bombs that become debt bombs.

Shhh though. Don't tell anyone else. It would be bad for confidence.

Do you think maybe Dr. Bernanke is just trying to talk his book too? After all, the U.S. Treasury has heaps of debt to sell this year (gross issuance over $3.25 trillion according to Goldman). If Dr. Bernanke makes adult sounds come out of his mouth, it might give people the impression the U.S. is returning to sobriety and fiscal sensibility.

And on due, ten-year bond yields did in fact fall in Thursday trading in New York. Ten-year yields on U.S. notes now stand at 3.54%. Remember that after the Fed said it would be buying U.S. bonds, yields plunged to 2.04% in November of last year. But by May 28th-as the true scope of America's debt bonanza became apparent to global investors-yields soared to 3.75%.

We still think bond yields are the prime mover in this market, but not for the reason that you'll read in the paper. Investors aren't selling bonds because the economic recovery is sound and stocks hold better value. You're seeing a bear market in sovereign bonds because many governments are running into a fiscal and demographic brick wall.

Bond yields also hold the key to explaining how a higher Aussie gold price is possible given the Aussie dollar's recent strength against the greenback. With the Aussie chugging along against the USD, it's been an uphill climb for gold prices in Australian terms. But just you wait.

The yield on Aussie ten-year notes was 4.88% in mid-May. It's now 5.67%. That's a 16% rise in three weeks. Granted, it's not the huge spike you've seen in U.S. yields. But it does tell you something.

It tells you that the Australian Office of Financial Management has its work cut out for it in selling the $1.4 billion in debt a day to finance the country's growing federal deficit. You borrows the money and you pays the higher interest rates. Or, your central bank-like the Fed-does its part if necessary to buy your debt.

Inflation on the way with real interest rates negative

Source: Reserve Bank of Australia

That sort of debt monetisation isn't on the cards yet in Australia. For now, there should be plenty of domestic and foreign investors willing to add a little high-yield government debt to their portfolios. But given the chart above that shows-by the RBA's own admission-that real interest rates are already negative, there are plenty of monetary forces already in the mix in Australia that will lead to expansion of the money supply.

That sort of monetary expansion, along with deficit spending and higher yields, is just the sort of thing that's going to power Aussie gold and precious metals prices higher. If it doesn't, we'll eat every single hat here at the Old Hat Factory.

Dan Denning
for The Daily Reckoning Australia

• What Inflation Means to Central Bankers, Investors and the Consumer
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Government Debt Bubble is What Directly Precedes Inflation
• How U.S. Mortgage Rates Affect Aussie Stocks
• Now in Post-bubble Era as Financial Industry Bombs Out

In the "no" corner, weighing in with some theatrically negative comments, is IMF managing director Dominique Strauss-Kahn. He told reporters yesterday that, "2009 will almost certainly be an awful year - we expect global growth to enter deeply negative territory. This is a truly global crisis, and nobody is escaping."

Nobody Wayne Swan. Did you hear that? Nobody! That means YOU!

Before we get to Australia's capital crisis and its Chinese future, just a quick note to say we won't be taking up the question we left you with at the end of yesterday's Daily Reckoning. It's the "what should we do" part of a world where the fiat money system cracks up, leading to a hyperinflationary/deflationary depression.

It's an important question-probably the most important you can ask these days. So we're going to collect and write up our thoughts over the weekend. Stay tuned! And if you want to send us your plan, don't be shy. dr@dailyreckoning.com.au

Meanwhile, what about the present? The IMF issues its World Economic Outlook twice a year. When times are good, the forecasts are too optimistic. When times are bad, the forecasts tend to be too pessimistic. And when times are really bad??

There is a problem for Australia buried in the IMF's comments we want to explore today. The problem is capital. Where is it going to come from over the next five years? Will Australia have a capital crisis?

The report says that one big consequence of the GFC is declining capital flows to emerging markets. With banks not lending at home in Europe and America, they certainly aren't lending abroad. The IMF said the decline in these capital flows, "may be protracted, given the solvency problems facing advanced economy banks that provide significant financing to emerging economies."

You could argue that Australia is not an emerging economy but an advanced, developed economy with two (and perhaps only two) world class industries (finance and resources). But what you cannot argue is that Australia is a net importer of capital and has been so for two hundred years. We didn't make that up. It's what the Australian Office of Financial Management told investors in a slide show in Dubai late last month (see slide 14). The AOFM hit the road-an investment road show-to entice investors to buy Aussie bonds. More on that in a second.

But first a question: would a prolonged credit depression choke of the capital imports that are the lifeblood of Australia's modern economy? After all, the Aussie housing boom was financed with a great deal of money borrowed from abroad. And the resource boom continues to depend on foreign capital (especially China) to expand. So is there a risk that Australia will experience a capital shortage in the coming years if the GFC drags out as the IMF expects?

We may surprise you and say the answer is "no." It's a qualified "no," though. First off, the banks are the largest importers of capital. If they have trouble importing capital, it's going to affect the Australian property market, both residential and commercial. But the government has already promised to fill this gap in two ways.

First, the AOFM was told by the Treasurer late last year to begin buying Residential Mortgage Backed Securities (RMBS) from non-bank lenders. It's been doing just that. And one interesting question is how much of the nearly $4 billion in RMBs the AOFM has already bought represent new loans made by non-bank lenders to First Home Buyers taking advantage of the big government grant.

If that doesn't sound like Fannie and Freddie buying subprime loans originated by Countrywide, we don't know what does. And we suspect that if the government wants to keep the housing market propped up, it will have to extend the first home buyer's grant past June 30th AND increase the role of the AOFM in buying securitised mortgages. After all, who else is going to buy them?

But while the government essentially underwrites residential property values via the AOFM, you can expect it to get busier providing capital to the commercial property sector too, via Ruddbank. You may have noticed that General Growth Properties, the second largest mall owner in America, filed for bankruptcy overnight. But even if you didn't notice it, we think this means the other shoe to drop in the second half of this year is major trouble in the Australian commercial property market. Why?

The Australian consumer is not much better off (by some measures he's worse off) than his American counterpart. Australians are growing their credit card balances, but paying off less and less each month, according to data published this week by the Reserve Bank. Credit card debt grew by 1.7% to $45.4 billion. But Aussies cut their repayments on that debt by 7.1%.

You'd have to expect major reverberations in the commercial property sector later this year if the Aussie consumer reaches his limit or loses his job. We expect that will lead to increased government borrowing and lending to prop the sector up in the same way it's propping the housing market up. It won't be cheap, either.

Ahmed Fahour is the man designated to run the Australian Business and Investment Partnership (ABIP aka Ruddbank). He is already expanding the mission of the bank beyond the backstopping of commercial real estate. He told the Australian Financial Review earlier this week that, "Right now, we're focusing on commercial real estate, but it does have the potential with all five shareholders to go beyond commercial real estate" (the five shareholders are the Big Four banks and the government).

Fahour has said the Ruddbank is a "backup plan" and not a bailout. But if things go to form in Australia-if capital remains scarce and the global economy continues to contract-Ruddbank will be a conduit between government money borrowed in the global bond market and Australian businesses that can't get capital any other way.

So how much is all this going to cost? A lot more than anyone expects, that's for sure. In its road show in Dubai last month, the AOFM produced a few slides that showed that Australia's net debt and debt-to-GDP ratios are quite favourable to other countries. And then it showed the chart below which projects the government's borrowing needs over the next few years. Have a look.

Australia to borrow over $40 billion each of the next three years

Click to enlarge

Source: Australian Office of Financial Management

So the Rudd government, through the AOFM, is hitting the road to hawk Australian government debt in order to pay for...well...for a lot of things. For the stimulus. For infrastructure. And, we reckon, for the funds to keep commercial property developers from going up and residential home prices from falling.

Of course there's no sin in being a net importer of capital. It means foreign investors are attracted to the rate of return on Aussie investments. But this is a trend that should worry any Australian who's had a chance to see what America has done to itself. It makes the country's economic growth dependent on foreign creditors.

A society that thinks it owes itself cash payouts and all sorts of other projects it can't pay for will happily borrow from the future to pay for the present. This is not so good for the future, though. What starts out as a temporary dip into debt to ride out a recession becomes a chronic habit of living above your means with borrowed money. Politicians support it because it's a way to keep the promises flowing without having to find ways to pay for them with current revenues.

The question we began with, however, is will foreign creditors like the Chinese and Japanese or the Petrol States simply cut Australia off and invest their money elsewhere (or in their own economies)? Right now the Federal Government enjoys a triple A credit rating from Standard and Poor's. But if the Federal government steps in to guarantee the borrowings of State governments (the same way it's guaranteed the borrowing of the big four) then the credit rating might not be so gold plated.

This means rising borrowing costs for the AOFM. This means the habit of paying for your projects with money borrowed from the future gets even more expensive (even if you call it 'investment' rather than say, 'plundering from the future'). This also means your taxes are probably going up (GST).

But it does not mean China will not be interested in Australian resources. And this brings us to the "yes" part of the question we set out to answer at the beginning of today's journey. Australia can mitigate the effects of severe recession, perhaps, by opening its arms wide to embrace its Chinese investors. Very wide.

Even though it was at a ten-year low, Chinese GDP grew by 6.1%, according to data released yesterday. That's good news. But as Michael Pascoe writes in today's Age, the better news is that the GFC is accelerating China's exit from its huge U.S. dollar reserves...and into tangible assets.

Pascoe points out that the commodities bubble has definitely popped, but that the boom is still on trend. Base metals and bulk commodity prices are lower than they were in 2008...but a lot higher than 2006 and mid-2007. He says prices have reverted to the rising trend, not crashed.

He also quotes Nobu Su, the head of a Taiwanese commodity firm, "China has woken up," Nobu says. "The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact and can cover their infrastructure for 50 years. The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources."

We hope Nobu is right. Over at the Australian Small Cap Investigator, Kris Sayce has tipped two Aussie rare-earth metal companies that could benefit from a boom in hybrid cars. That would be welcome news indeed.

But the larger argument and question is if Australia will ride out the GFC on China's foreign investment coat tails. Even that is no sure thing. It's one thing to sell Aussie resource firms to Chinese partners. But how will that halt rising unemployment? How will it save the retail economy? What will it do for house prices and commercial real estate?

Despite the "glimmers of hope" and "signs of stability" alluded to by talking heads and politicians, we see nothing of the sort. This kind of talk is just self delusion. It wouldn't surprise us at all if the people saying these things are in the meantime burying gold in the backyard and hoarding bottled water in the spare bedroom. More on survival strategies for the rest of the year next week!

Dan Denning
for The Daily Reckoning Australia

• Australia to Borrow as Much as $300 billion
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Australia Ponders its Chinese Future
• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…