And counter to our prediction of an imminent, counter-trend U.S. dollar rally, the dollar is most definitely not surging. Take a look at the chart below. We've been writing about the decline of the dollar for nigh on ten years. So we looked at a ten year chart to tally up the damage. It is considerable.

Click to enlarge

What's at stake with the interpretation of this chart? If the dollar rallies on short covering from the dollar carry trade (a BIG if), then other "risk" assets like gold, stocks, and emerging markets would probably sell off. And yes Australian stocks, that includes you. As well as the Aussie dollar.

The chart shows that the index's 50-week moving average is set to cross below its 200-week moving average. That is mixed news. The first time it happened on this chart was back in early 2003. That was the early days of a long decline in the index. The second time, though the move failed to confirm the "flight to safety" rally of 2008 had staying power in 2009.

Once the fear that gripped markets in 2008 went away, the investment world sold the dollar and started borrowing en masse to buy other, higher-yielding currencies and assets (like the Aussie dollar and resource stocks). That's where we are now.

But based on the chart, is the next move down in the dollar index a new low, which the crossing of the long-term MA by the short-term MA would suggest? Or is it a false move? Will the dollar quickly and violently rally for some reason (geopolitical perhaps) that currently remains unknown to the human beings of this world?

"It's an interesting chart," said our technical analyst Murray Dawes. "But it is not useful for timing your moves out of or into trades related to the dollar's movement."

"So you're saying our chart doesn't have any useful information from a trader's perspective?"

"Not really."

Murray promised to show us HIS dollar index chart tomorrow. We'll bring it to you, live and in colour. But in the meantime, we think the one piece of important information communicated by our chart is that the dollar's trend is down. But there IS a catch.

The catch is that when this many people are this uniformly bearish, everyone is probably wrong. Consider this a warning then, that a dollar rally is just the sort of thing that will lead to a correction in the gold price and the stock market. We won't speculate on the sort of things that could lead to a dollar rally. But surely they're out there and sooner or later they'll come.

The other possibility is that the dollar is in its death throes and that this is the big one, in currency terms. That is such a momentous and disastrous event that people consider it both kooky and unlikely, not to mention undesirable to a predictable and comfortable world. But it IS possible.

And do you get the feeling that this kind of manic melt up rally is the sort of irrational frenzy that comes just before everything goes haywire? Haywire is not a precise financial term. So what do we mean?

We meant that the world enjoyed a 20-year economic relationship based on a fundamentally unbalanced global economy. Manufacturing capacity migrated to Asia where wages were lower. For awhile, this was mostly good news in Western countries. Goods got cheaper but jobs didn't vanish.

Now the situation is not so pleasant. The world is awash in manufacturing over-capacity, especially in China. Wage deflation (in the Western world) looks like a long-term trend, leading to a lower standard of living. This wage deflation is occurring at exactly the same time that Western governments are encountering demographic crises of ageing populations.

We all knew the ageing of the Boomers would put pressure on public finances right around now. But no one reckoned on a global financial crisis further saddling the public balance sheet with debt. And no one reckoned that Western wages and incomes would be falling at just the time people needed them most. And no one reckoned that savers would lose the most from low interest rates on fixed income - even though those low rates are keeping the American housing sector on life support.

It's a bit of global impasse. America's needed structural adjustment has come. Households and businesses are reducing debt, trying to live within their means. But the net adjustment to the American balance sheet is not happening because public sector debt is growing so fast.

Meanwhile, the other obvious adjustment is that the Chinese currency ought to be allowed to strengthen. For political and social reasons though, China will not allow this. It means China is actually adding to its industrial over capacity. It is conjuring up the world's largest ever bubble in fixed asset investment, including commercial real estate.

It is easy to see why China is reluctant to allow a stronger Yuan. Exports account for 39% of Chinese GDP. The Chinese economy, and probably the Communist Party itself, cannot survive on unleashed Chinese domestic demand. They need American markets. But American consumers - in addition to reducing debt - are now realising that the focus on finance over manufacturing from American policy makers has worked out for Washington and Wall Street, but not terribly well for the average American worker.

Where do we go from here? How about the blame game. U.S. Treasury Secretary Tim Geithner once blamed the Chinese for being currency manipulators. He back-tracked later. And yesterday, Liu Mingkang, the chairman of the China Banking Regulatory Commission, had a go at America.

"The continuous depreciation in the dollar, and the US government's indication that, in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation." He is blaming the U.S. for fuelling a destabilising global bubble.

Of course that bubble is felt most acutely because China pegs its currency to the dollar. China is right to blame the U.S. for manipulating its currency to try and improve its competitive position. And China is right to worry about the value of its dollar-denominated assets in a world of exploding U.S. debt supply.

But China has put itself in this position. And here we are at the end of 2009 with a world still fundamentally un-adjusted to a new, workable currency arrangement. The world remains burdened by trillions in assets purchased with debt. Those assets linger on bank balance sheets, on government life support but fundamentally lifeless at fictitious book value prices.

And meanwhile, the China-US currency arrangement has fuelled a global bubble. Australia is part of this bubble, too. The question is how it will end. In the U.S., the housing market looms as the Achilles heel of the economy. It could strike households, banks, and the government again in the next 12 months are more mortgages reset at higher rates (with lower home values).

If the event that pops this bubble comes from America, look for the supply of credit to the emerging world to dry up again. And though Australia is not a developing economy, we saw last time what happened when U.S. credit markets imploded. Australian banks had to get a government guarantee to borrow money in the wholesale market.

We'd suggest that lending for residential housing and commercial real estate would take a real dip in Australia on another U.S. housing crisis (even if Aussie banks aren't exposed to actual U.S. housing-backed RMBS and CDOs. You don't have to own toxic debt to be impacted by it.

If the bubble pricking comes from China, what then? Well, China does everything big. So a Chinese bust would be world-class. It's a subject that requires its own Daily Reckoning. More tomorrow.

Dan Denning
for The Daily Reckoning Australia

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And yet I eat a lot of Chinese food, which seems somehow unpatriotic, but like most self-absorbed gluttons, I cannot stop because I don't want to, just like I still eat tacos even though Mexico is taking over the USA, and I am uneasy about that, too, and I walk around outdoors without an aluminum foil hat to shield my brains from interstellar rays and invisible CIA cameras reading my thoughts.

News.bbc.co.uk had nothing to say about how one's dietary excesses are reflective of one's patriotism, or about any of my other weird paranoid delusions, either, but it did say that (just as bad) up to now, "Most of China's foreign trade is settled in U.S. dollars or the euro, leaving exporters vulnerable to exchange rate fluctuations" and, of course, vulnerable to all the little bites taken by middlemen.

Now, "China has said it is to allow some trade with its neighbours to be settled with its currency, the yuan. It means if the two parties to a trade have yuan available, they need not enter world exchange markets to pay", which will save them both a lot of time and money, as they can bypass all those expensive intermediaries that each take a little bite of your action.

Now, without these parasites, the inflationary implications caused by such cost-push factors are eliminated! Inflation goes down!

Anyway, the announcement is almost a fait accompli, as "Analysts told Chinese media that the yuan was already being used in some South East Asian countries and that China was happy to see such use extended", which suddenly explains many of my unnamed fears and a lot of frightening nightmares about being eaten by gigantic egg rolls, instead of the delicious other way around.

Well, egg rolls or not, pretty soon everybody is going to have more egg rolls, as the Chinese are engaging in massive stimulus spending, too, just like we and everyone else are, and "announced more measures to stimulate domestic consumption", which included such things as "subsidies to rural households for the purchase of household appliances and other goods, and the setting up of new stores and distribution centres in rural areas."

Subsidizing raw consumption! Wow! Now THAT'S stimulus spending! But maybe such heroic measures are just to take up the slack, as the Chinese are taking a whack, which is almost poetic, which is why I wrote it that way, but also for dark, mysterious reasons about which one can only speculate and shudder, but mostly because the Commerce Department announced that consumer spending in America fell 0.6% in November, and U.S. exports fell for a third straight month, which is a lot, which also explains why the Chinese are taking a whack from slack!

What slack? From Marketwatch.com we learn that the Federal Reserve reported, "Stung by the loss of $2.81 trillion in their net wealth, U.S. households paid down their debts in the third quarter for the first time since at least 1952."

The actual numbers are that "As of Sept. 30, households' total outstanding debt shrank at an annual rate of 0.8% from $13.94 trillion to $13.91 trillion", the difference being a hefty $300 billion in foregone consumption right there, unless it was all offset by higher incomes, which it wasn't! Gaaahhh! We're freaking doomed!

As staggering and as bewildering as to what any of this could possibly mean, it was not until later that they reveal that when you adjust this fall in nominal consumer spending for the effects of inflation (perhaps using the recently revised Gross Domestic Product Deflator that shows that inflation in prices is 3.9%?), then "Real consumer spending rose 0.6%", which seems weird and contradictory until you remember that "Everybody's lying to me and that is why I understand nothing", and then everything makes sense again.

And that sudden clarity, that transcendental moment of total consciousness, is when you realize that you can trust only gold, silver and oil.

You wish you could trust The Mogambo, too, but you've seen how he looks at your wife behind your back, and you realize, "This guy's a real scumbag! But maybe his advice about gold, silver and oil is good, which will make up for it!"

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

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