But we completely forgot about Dubai. It came up yesterday in conversation briefly with our colleague here in New Zealand under the topic: greatest misallocations of credit in history. We were talking about the wisdom of turning oil money into indoor ski slopes in the desert.

Today, however, we'll be talking about whether Dubai could default on its debt. German, French, and British stock markets were all down over three percent overnight. The worry in markets is that Dubai could delay its debt payments. It would, according to Bloomberg, be the biggest sovereign debt default since Argentina in 2001.

Dubai World - the group that built an island shaped like the world - has $59 billion in liabilities. It has sought a "standstill" agreement from creditors. That includes $3.52 billion in bonds due on December 14th, which according to our calendar is in a couple of weeks or so.

Dubai World has assets all over the world. It has casinos in Vegas and banks in London and luxury goods stores in New York. Presumably it has assets it could liquidate to pay some of the debt. But there's a lot of debt.

Bloomberg reports that Dubai borrowed nearly $80 billion over a four-year period. That borrowing - made possible in a way by the income stream from energy exports and rising energy prices - went straight into one of the worlds more impressive and outrageous property booms. But the bust has wiped nearly 50% of property values in Dubai and now this, the risk of sovereign debt default.

And suddenly the move into short-term U.S. Treasuries looks understandable, if not sensible. Emerging markets sold off on the Dubai news. And in the scheme of things, if you're going to own sovereign debt risk at the moment, perhaps 90-day U.S. paper will cause you the least anxiety. It's not a major commitment either (thirty years, for example).

How all this plays in Australia today will be interesting. We notice that Australian Small Cap Investigator editor Kris Sayce has trailing stops triggered on three positions over the last two days. Kris is taking profits on energy stocks mostly. The virtue of the trailing stop - other than turning a paper gain into a real profit - is that it makes the decision to sell a lot less emotional. If the stock hits your stop, you hit the sell button and take your money off the table.

However we're assuming the selling momentum in the market will pick up. Wall Street managed to buck Europe's negative lead. The Dow managed to close up for the day. And in the currency market, the greenback rallied against a whole basket of currencies, from the Vietnamese Dong to the Brazilian Real to the South African Rand.

That's the kind of move - paired with the flight to sovereign bonds on the Dubai news - that could produce the dollar short-covering rally we wrote about several weeks ago. When so many people are short (especially with leverage) a short-squeeze can see huge moves in markets as investors and traders are forced to sell leveraged positions (emerging market stocks and high yield currencies) and repay their dollar loans before the currency gets much stronger.

Mind you, as we believe Voltaire once said, all paper currencies eventually reach their intrinsic worth. But between now and then, you might want to buckle yourself up for a powerful U.S. dollar rally. It will defy the fiscal and monetary fundamentals in America. But this market is not trading on fundamentals at the moment.

This mean's the Aussie dollar's march to parity against the greenback may be on hold. Even oil dropped off the pace a bit. Another round of global deleveraging would not bode well for economic growth, which would not bode well for oil. For now, only gold seems to be holding the line - perhaps because the demand for gold is not economic but monetary. December gold futures traded up over five dollars to $1,193.80.

Meanwhile, ominous sounds are coming from the U.S. banking industry again. The Wall Street Journal reports that in the third quarter, loans by U.S. lenders fell by the largest amount since the government began tracking such things. Loan balances fell by $210.4 billion, or 3%, according to the Journal.

This confirms the suspicion that banks aren't lending...at least not to businesses and consumers. Banks are, instead, lending to the U.S. government via purchases of short-term U.S. bills and notes. We dispute the idea that it's "risk free." But it probably beats new mortgage lending by a good margin. And some banks - already struggling to stay solvent - wouldn't be keen to put any more money at risk.

The Journal reports that, "The FDIC's quarterly banking profile, which analyzed data from 8,099 federally insured banks, reported that 552 financial institutions, with combined assets of $345.9 billion, were on the government's problem list at the end of September, up from 416 with $299.8 billion of assets at the end of June. That means roughly 7% of all U.S. banks are on the list and face a higher probability of failure."

That is not a misprint.

It is, however, a warning. The GFC isn't over. The FDIC story is about a coming American banking crisis. But it will surely affect global liquidity, which makes it an Australian story too.

The Fed began inflating the bond market a year ago with its planned purchases of Treasury bonds and agency debt. By telegraphing its intention to support bond prices, it fed the bond bubble. This pushed U.S. interest rates even lower, which made borrowing dollars to buy other things all the rage.

And 2009 has been all about the rage. Borrowed dollars have bid up assets all over the planet yet again. The debt side of the balance sheet has not been appreciably shrunk, meanwhile. Asset quality at banks has not notably improved. And national governments have actually gone the other way, expanding their liabilities to try and plug the spending gap in the economy left by the departure of consumers from the field.

Here we are at the end of the November, with the whole leveraged financial economy seemingly at another Lehman - like moment. The cost of insuring sovereign debt against default is rising in the Middle East. Investors are tallying up the year's profits and deciding enough is enough. It's time to sell and buy some gold and government bonds.

Is this a case of post-Lehman jitters? Is it a minor aftershock to the major temblors of the last two years? Or is it a sign of the "big one" to come? It's hard to imagine financial events can get any bigger or worse than during the last few years. In fact, we can think of only one, the Great Depression. It's beginning to look awfully familiar.

Dan Denning
for The Daily Reckoning Australia

• Dubai, Built on Debt and Sand
• Dubai Debt Story More Like Bear Stearns Less Like Lehman Brothers
• A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold
• It All Comes Down to Debt Again for NAB
• U.S. Bonds Better than Greek or Other Sovereign Bonds

There are some pretty big issues we left hanging with yesterday's DR. Are the Western Welfare States (the U.S., Japan, and EU nations) really going bankrupt? Things were headed that way before the credit crisis began. If Rogoff and Ferguson are right and the GFC is becoming a sovereign debt crisis, it will worsen an already bad situation.

How bad? We'll show you three of the charts we showed the folks in Canberra on Sunday. This is the condensed version of a forty-five minute presentation. So we'll have to leave out the colour commentary. And we're pleased to offer another contribution from Dr. Steve Kates on how government policy is destroying public wealth.

But first, check out the chart below from the 2008 annual budget audit by the U.S. Government Accountability Office. It shows that the U.S. government must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches).

What's the big deal? $3.4 trillion is a small number by today's standards, isn't it? Not exactly.

The chart shows how incredibly interest-rate sensitive U.S. government borrowing now is. Not only is it a big ask to ask the world's creditors to continue funding such large deficits (there are only so many savings available to borrow, after all), but the interest expense on that debt is likely to go up as the fiscal position of America deteriorates.

And if America can't find anyone willing to finance its deficits, what then? Well, the luxury of issuing debts in the currency you also print is that you can print money to pay for them. Technically, you can never become insolvent when you enjoy this privilege. The Fed, for example, can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

But this monetisation of the debt is another way of saying that international creditors are no longer willing to pick up America's spending tab. They will be betting against the American economy, not on it. Even if the Fed takes the unusual step of moving out further along on the yield curve to set interest rates (and keep the bond vigilantes from sending yields to the moon) this is a clear signal to owners of dollar-denominated assets and holders of dollar currency reserves to get out.

Another scenario to watch for is when creditors begin asking the U.S. to issue debts in currencies other than its own (Yuan, Euros). That would be something. In the meantime, they will look to lessen their dollar reserves.

That may not be such an orderly process. And the urgency to get out of the greenback and into something better will only pick up pace as it becomes clear the politicians in America (along with the Fed) are not likely to suddenly rediscover fiscal prudence.

You never know. The Fed may assert its independence and baulk at more quantitative easing. But we wouldn't count on it. And we reckon tangible assets and possibly emerging market equities would be the biggest beneficiaries of capital flows out of the dollar...and into anything else.

The next chart is for you, Paul Krugman. Krugman, among others, continues to insist that larger public sector deficits are necessary if the Western world is to avoid a Japanese-style deflationary "Lost Decade." He claims the government must increase spending as households and businesses deleverage and reduce debts.

Advocates of this idea claim that public sector deficits, as a percentage of GDP, have no real limits. And the example they cite is Japan. As you can see from the chart below, Japan's debt to GDP ratio is nearing 200%. America's isn't even half of that yet (it's about 98%, or $13 trillion). If Japan can finance a deficit at 200% of GDP, then why are we worried that U.S. deficits half that size would threaten interest rates or the dollar?

First off, it's worth pointing out that high public sector-debt-to GDP ratios haven't worked in Japan, if by work you mean pave the way to a stable recovery. Advocates might say-as advocates of the stimulus here in Australia often say-that the public spending made things less worse. But the opposite is true. It's made things more bad!

Or just worse, if you prefer. We mean that the public spending has done two things, neither of which is productive, and both of which, in fact, waste capital and resources. First, public sector spending to prop up financial firms with dodgy assets prevents the needed reckoning in asset prices that would produce market clearing prices for commercial and residential real estate. You get zombie banks and a zombie economy and zombie house prices.

Secondly, there's no indication that all the infrastructure spending in Japan has produced any kind of lasting growth for the economy. It may have built some great roads and bridges. But we wonder if it solved any of the underlying problems? What' more, the capital and resources that went into those projects was directed by political considerations and not available for the private sector, which could have put them to some use at least designed to produce a return on the capital.

The underlying problem which deficit spending does not solve is compounded by demographics. Japan's government is hoping that continued borrowing can be financed at low rates by pensioners who will be cashing out of their pensions but seeking safety. However, we suspect that Japanese pensioners will begin to consume their savings as they downsize their lives into their twilight years (which tend to last much longer in Japan, as the number of Japanese centenarians shows).

That means interest on Japanese bonds-which already one fifth of the Japanese budget-will consume even more of the nation's resources, if the older population clams up with its money. And like in the U.S., you'll see the government borrowing more and more of every new yen spent, with more of that borrowed yen going to pay a previous creditor. That's bordering on Ponzidom.

Japan has been able to run a higher-than-average public debt-to-GDP ratio because it has had such a high personal savings rates. This kept borrowing costs low for the government. But we'd expect that to change soon. A debt-to-GDP ratio of 200% will be very difficult to finance in the world as it is-much less in a world where those rates begin to rise and when Japanese savers begin to consume their savings.

Finally, what about Europe? Our argument here is simple: Europe's monetary union is going to come unstuck. Why? Europe has one interest rate for twelve different economies. That does not leave national governments with the flexibility to print money and inflate away political problems. This will be intolerable, the monetary union will break up.

The sign to watch for is a spike in the yields on euro-denominated debt. As the chart below (from Stratfor) shows, earlier this year bond yields did in fact begin to widen. Germany Bunds have the most stable rates, as Germany has traditionally the most stable fiscal and monetary policies in Europe (they did not go hog wild for stimulus).

But for Spain, Ireland, Greece, Portugal, Italy and Austria (whose banks lent large for real estate in Eastern Europe), another round of falling asset values really would show that the GFC has become a sovereign debt crisis. And will Germany bail out these nations? Can it afford to?

We don't know the answer to those questions. But it is worth pointing out that by assuming or guaranteeing the liabilities of the financial sector, national governments have also assumed the risk. And the bond markets will be left to decide how to price this risk.

How it ends is anyone's guess. But our take is that the Super Cycle in fiat money is at its peak. And as it unwinds, it's going to take national governments and their financing model with it. They will be forced to adopt a new model and take a new form to survive.

This means a great deal of political and economic upheaval. It's no coincidence that the last time the world faced such monetary upheaval was when it went off the gold standard and straight into essentially thirty two years of military and economic conflict (1913-1945). If the world is about to become that disordered again, you'll need a plan to deal with it.

Dan Denning
for The Daily Reckoning Australia

• Japan and its Economy Did Not Have Secret to Everlasting Success
• Only Thing Rising Faster than Demand for Government Debt is Supply of It
• Investing in Japan…
• Government Debt
• U.S. Treasury Auctioning Off $81 Billion in New Debt

In part due to this shift, these economies - China, India, Brazil, etc. - command an increasingly important role in the geopolitical arena. In addition, these New Economies on the Block are forging important trade ties with each other and inking deals to secure their mutually beneficial future, ex-US.

The United States, meanwhile, is up to its ears in ever-mounting debt...both to its creditor nations in the Middle and Far East and, to an even larger extent, to its own citizens.

And so we ask ourselves, will the young Johnnie and Jenny Smiths of the West be able to bluff their way through the next round of negotiations with a pair of twos? Or will the Changs, Patels and Ahmeds of the world call their bluff and take them to the cleaners?

Unfortunately, the trouble started for Generation iPod before they even had a chance to cause it for themselves. "Like America itself," observes Bill Bonner, "[Young Americans] are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the 'Morning in America' that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives."

Much of America's international influence was acquired during a time when the dollar roamed free and easy as the world's reserve currency. French President Charles De Gaulle called it an "extraordinary privilege."

At its height, the greenback commanded a magisterial awe and its position was largely considered unchallengeable. But no challenge is too great for the mighty US government...especially the challenge to debase its own currency.

It is true that extraordinary privileges carry extraordinary responsibilities. Within a single generation, the irresponsible goons in charge of preserving the dollar's integrity had destroyed almost all of its purchasing power. Measured against gold, it has slumped some 97% since Nixon closed the gold window in '71. And now, when the Treasury Secretary of the United States of America tells a classroom of Chinese university students that his nation's currency is trustworthy and reliable, they laugh in his face.

Then, on top of an increasingly worthless currency, Generation iPod also inherits about a quarter of a million dollars each in unfunded Social Security and healthcare obligations, the overdue infrastructure bills of a crumbling nation, a couple of distant wars to fight and die in and a world full of disgruntled foreign creditors.

Is there any hope?

Opined John Mauldin on the subject in Tuesday's issue: "It is not the times which dictate the man (or daughter!), but the response of the man which dictates his own time. Today has a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it..."

Echoes Bill, "The real advantage in life is having the gumption to get on with it; no one knows where that comes from."

Indeed, history provides us with countless examples of individuals triumphing over adversity. A hard working American student has every chance to succeed in life, as does a hard working Asian student. It's just that, on the whole, graduating classes of Asian engineers and computer programmers are far more diligent than graduating classes of Western feminist film studies students.

Taiwanese university graduates, for example, would happily take on the workload of most western jobs as a vacation, never mind as a vocation. The forty-hour workweek (35 for our French readers) is something students here manage between classes...and cram sessions...and helping run the family business...and music lessons...and English school in the afternoons and evenings. Not only have the Asian countries already outworked the west over the past generation - by a measure significant enough to now own virtually all of the western countries' debts - but they continue to up the ante even now. They have raised the bar, in other words, and they are raising it still.

A generation ago, Mao Tse-Tung did his people a huge favor and finally died. His successor, Deng Xiaoping then told the Chinese masses not to fear wealth and that, in fact, to get rich was "glorious." It was a stark contrast to the self-immolating edicts spewed forth from Mao. The people rejoiced...and got to work. Last year, China created millionaires at the second fastest rate of any nation on the planet. Only India outpaced her. Meanwhile, America "demoted" millionaires quicker than any other country could manage. England was next on that dubious accolade.

The people in this region of the world are hungry...and they are only now beginning to taste the fruits of their labor. As finite resources - energy, food, land, water - stretch over the coming years to meet exponentially growing demand, Generation iPod needs at least to know what they are up against in the scramble to stake their claims.

And, not unlike the Eastern generations of yore, they must work hard to succeed, despite the impediments their government impose. This unfolding reversal of fortune between the West and East does not simply suggest that American college students might face a less inviting future than their parents faced. It also suggests that investors might find a more inviting future in the Emerging Markets than they will face in the Developed Markets.

Joel Bowman
for The Daily Reckoning Australia

• Getting the New iPod to Work
• Government Pretends to Punish the Bankers
• HSBC Reveals Days of the Dollar are Numbered
• India Can Grow for Many Years
• Emerging Markets Are Still a Buy

One day does not a trend make, dear reader, but it does us give pause for thought. What if we dollar bears are wrong about the greenback's fate? What if all these column inches spent bashing the buck - and the frauds at the Fed in charge of protecting it - all come to naught?

"Nonsense!" we say.

Mankind will eventually bury the greenback in the cold, hard ground, alongside every fiat currency that ever went before it. The only question, it seems to us, is when the first shovel of dirt will be thrown. Traders from New York to New Delhi are gathered around the open pit, but they may have to wait, at least for a while. Just to be on the safe side, we've bought a golden shovel, but for now we're content just leaning on it.

Here in the Far East, the dollar is a particularly curious entity. Once upon a time, the mighty greenback was the best show in town, the "must have" ticket for the rocking Asian economies. China, Korea and Japan all amassed gargantuan stockpiles. The three hold about US$4 trillion (with a "T") in foreign reserves, much of it in US Treasuries. Even Taiwan - an island one-third this size of Tasmania but with a population equal to Australia - has stashed away the equivalent of US$332 billion in foreign reserves.

But that was then. This is now. And now everyone knows what all those dollars - and the men who stand behind them - are really made of...paper and promises, promises and paper. And now that the game is up, everyone is betting on a dollar collapse. But that presents a problem, and an opportunity, in itself...

"Whenever you find yourself on the side of the majority," Mark Twain once observed, "it is time to pause and reflect."

Right now, every necktie on television is betting against the dollar. The Powershares DB US Dollar Index Bullish and Bearish Funds - which measure the sentiment for and against the greenback versus a basket of six major currencies - are showing dollar bearishness in the extreme. But what if this "recovery" is not all it's cracked up to be? What if equity markets suddenly start resembling reality - even for a short while? If risk appetite contracts, even marginally, might we see a rally in short term Treasuries...just like we did last time? And just how quickly will currency traders be able to cover their short dollar positions if such a scenario unfolds?

We don't know the answers, dear reader. We only observe that the larger the mob, the more likely it is to be galloping in the wrong direction.

So are we dollar bears, or bulls? The answer, dear reader, is both - the former over the long haul...but the latter before then.

Dan Denning, our friend and colleague on our Australian DR desk, puts it thus: "Though we are confirmed US dollar bears, the dollar is looking oversold. Stocks are looking overbought. And frankly the reflation of all asset markets (bonds, stocks, commodities, and real estate) is looking over cooked... Watch out!"

Asian and European markets largely floundered overnight after Wall Street's lackluster session yesterday.

Here in the Far East, Japan's Nikkei 225 dipped 1.35% by the close while Hong Kong's Hang Seng and the Aussie All Ords ended down by 1.85 and 1.45% respectively. China's CSI index was the only major measure to buck the trend. It finished higher by 0.45%.

Back to the European measures and London's FTSE, Germany's DAX and France's CAC 40 all finished lower by around 1.3% for the day.

In the commodity pits, crude had slipped back a bit last we checked. A barrel of the world's goo was down about 60 cents to just shy of $79. Gold was hanging on around $1,036 per ounce...but looking a little punch drunk.

Until next time...

Cheers,

Joel Bowman
for The Daily Reckoning Australia

• Inflation Up… Gold Up… Oil up… Dollar up… Dollar down…
• HSBC Reveals Days of the Dollar are Numbered
• The Only Thing Really Going Down Right Now is the U.S. Dollar
• When People Fear Inflation or a Falling Dollar They Find Refuge in Gold
• U.S. Dollar Strength or Oil Weakness?

"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

The front page of today's Australian Financial Review has a time-lapsed picture of cars travelling on what apparently is a "Superhighway Paved with Gold." Ah! No wonder gold is going up. It would take a lot of gold to pave a superhighway.

The caption underneath the picture reads, "There's big money to be made from the new tech boom by investing in internet stocks and telecommunications players." And this story just so happens to be published hours after Apple told the market it sold more iPods and Macintosh computers in the fourth quarter than ever before. The crowd went wild.

Apple shares finished up about 5%, just under US$200. Since they bottomed at $78.20 in January, shares in the company have soared by 154%. That's certainly a big enough rise to get your attention. But as with the A-REITS we mentioned yesterday, if you were going to buy into the bogus recovery, the time to do it was eight months ago - not yesterday.

Mind you Apple is an interesting business that might have the ability to deliver great earnings growth through the teeth of a global depression. We doubt it. But iPods have become pretty indispensable in modern culture. You never know.

But today's Daily Reckoning has a simple point to make: watch out! The only thing really going down right now is the U.S. dollar. And that gives us the heeby jeebies. Last time there was such a consensus about the dollar's short-term direction, everything reversed, and quite suddenly.

The last time the dollar index broke out from its lows was in June of last year. Once it busted out, it set off a chain reaction in financial markets. Investors got out of risk assets and back into short-term U.S. Treasuries. Stocks went down, and Aussie stocks were no exception.

In fact, as you can see below from the chart (courtesy of Slipstream Trader Murray Dawes), there is a pretty clear relationship between the week greenback and the All Ords. Murray inverted the dollar index scale to show the correlation more clearly. The bottom line is that if the dollar index strengthens (the blue line goes down), the All Ords will weaken (the black line will go down too).

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A dollar rally and an equity selloff are even more likely now for two other reasons. First, any time you get a carry trade - in which investors borrow a cheap currency to buy assets - there is always the risk of a short squeeze. Investors who are short the dollar cover that short by buying back the currency.

Right now, as you can see from two more charts below, investors are about as bearish as they've been on the dollar (or least bullish, if you prefer). The Powershares DB US Dollar Index Bullish and Bearish Funds measure the greenback versus a basket of six other currencies, the Euro, the British Pound, the Canadian dollar, the Japanese Yen, the Swedish Krona, and the Swiss Franc. One shows dollar bullishness nearing a new low. The other shows dollar bearishness reaching a new high.

Click to enlarge

Click to enlarge

The second reason to expect a reversal in the dollar and a sell-off in stocks is that stocks are pretty overvalued at the moment. John Hussman at Hussman Funds writes, that, "On the valuation front, stocks are presently overvalued, but to levels that we've observed at least several times in history. The anomaly relates to market action, where we can no longer find a single historical instance where stocks were more overbought on the combination of short - and intermediate - term measures we respond to most strongly. Indeed, only one instance comes close, which is November 28, 1980.

Hussman then adds that, "One of the notable features of extreme overbought conditions is that investors rarely have much opportunity to get out, just like the fast and furious advances that clear oversold conditions tend to occur too quickly to capture unless one has already established a position. As for the present, we have rarely seen 90% of stocks suspended above their 50 - and 200 - day moving averages for as sustained a period as we have now observed."

Of course Hussman is writing about U.S. stocks. What about Aussie stocks? We asked Murray to see if the Aussie market looks overbought on a technical basis as well. He sent us the chart below, and the brief answer is "Yes!"

Click to enlarge

"A quick look from 10,000 feet really shows us how overbought the market is at the moment," Murray comments in his note. "The weekly MACD (which shows us the relationship between a long term and short term moving average) has not been this high very often in the past 30 years. A quick look at all of the times it has been this high shows some interesting facts.

"The final blow off rally before the 1987 crash took the weekly MACD to a level below where it is now (the thin blue line). In 2006 when it reached the same level as in 1987 we did have a correction in the market, although it didn't last too long and we eventually headed higher for another year.

"The final rally before the credit crunch in 2007 took us to a level which is about where we are now. Do you think it was a good idea buying stocks in early 2007?? Not really. The market has now retraced to within a whisker of the 50% Fibonacci level. And the long term moving averages are saying that we are still in downtrend.

"The risk of entering the markets at this time is very high. Any longs should have tight stops, but any shorts need to wait until short term momentum indicators have shifted into negative territory which they haven't as I have stated in the past. It could be a good idea to take a bit of money off the table if you are sitting on good profits from the past few months. When the music stops you will only get a chance to sell with everyone else and it will be at much lower levels in the blink of an eye."

Have we switched religions on you? Not all. We're still a confirmed U.S. dollar bear. But a sudden collapse in the dollar is not in the interest of any trader or investors who have large dollar-denominated assets. And traders are amoral anyway. You trade the trends and the trends never move in a uniform direction.

So consider yourself warned. Though we are confirmed U.S. dollar bears, the dollar is looking oversold. Stocks are looking overbought. And frankly the reflation of all asset markets (bonds, stocks, commodities, and real estate) is looking over cooked.

Dear Dan,

Merv

We'll have a think on it Merv. "Dan Denning, hanging out with the meth heads and prostitutes in St. Kilda" doesn't seem very family friendly. But truth be told, the company you find in St. Kilda is still better than hanging out on Collins Street.

Dan Denning
for The Daily Reckoning Australia

• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• Looking at WPL and Oil Side by Side
• S&P/ASX 200 Clears Resistance Line
• The U.S. Dollar is Not the Euro
• Investors Think Things Will Return to the Way They Were in the Bubble Epoque

The Guv also said he would not be too timid about raising interest rates. He believes the threat [of global financial calamity] has passed and that the bigger threat may well be inflation. That kind of tough talk sent the Aussie dollar right up to over 92 cents against the greenback. If it weren't late fall, now might be the perfect time to take a trip to America and see how cheap things really are.

But it is a bit surprising that a Central banker would say he's not sure there WILL be another shock to the world's financial system. The last twenty years show a history of regular shocks. The economic models of economists suggest these shocks are 100-year or even 500-year events. But they just keep happening!

The Peso Crisis...the Asian Crisis...the Russian bond crisis which led to the fall of Long Term Capital Management...Bear Stearns...Iceland...Northern Rock...the entire GFC...nope! None of those could ever happen again. Especially in a world that's reducing debt where asset markets are now undervalued and house prices have dramatically corrected and banks have recapitalised.

Well, that's the story that Stevens probably believes. But you know our view. There's a lot more bad debt out there posing as assets. There are more credit write downs. Banks have a boatload of commercial real estate and residential housing assets and a thin slice of equity capital supporting them. There is still a lot of leverage in the financial system. And that leverage exposes banks to losses.

For example, today's AFR cites research from the International Monetary Fund and concludes that Aussie banks could lose as much as two percent of total loans outstanding if corporate and household defaults increase. And gee, that's not likely at all when interest rates rise quickly, is it?

According to the AFR, the IMF report does conclude Aussie banks are "very sound", but they could lose $33 billion from rising defaults. We're not sure what default rate the report assumed, but we reckon it was probably too low. Nearly everyone in the financial establishment underestimated the depth of the crisis last time, too.

The other threat is that that Aussie banks source 30% of their loan funding from international credit markets, according to the IMF. Australia's short-term external debt is about $400 billion this year, according to the AFR. Is that really a threat?

It doesn't seem like one right now. Interest rates are rising and the Aussie dollar looks like it's headed to parity against the USD. This makes Australia a popular destination for international capital flows. After all, you have heaps of foreign investors pouring in to buy Australian property. The place is a capital nirvana!

But yes, it is vulnerability. For one, it means growth in the Australian economy is not sourced from domestic savings but from borrowed foreign money, which must later be repaid. Second, it means that the income and rent from Australia's capital stock (houses, property, shares, and bonds) may not be making Australians rich or even staying in Australia.

Granted, if the Boomers are selling their houses to Chinese investors in order to finance a comfortable retirement, it should work out well for the Boomers. But their children may be renting from Chinese landlords for a long time to come. And no, we're not blaming the Chinese for this at all. It's a great move for Chinese investors. But it may not be such a great development in the capital structure of Australia.

But at the moment, you wouldn't get that sense that rising public debts and the transfer of ownership of Australia's capital assets are any worry whatsoever. Sure haven't seen much of it in the papers or on the TV shows. It's like everyone's forgotten that the more integrated the world's financial markets have become, the more they've tended toward instability. Or everyone believes whatever was wrong before has been fixed now.

One person who had his wagon fixed yesterday was Bank of America CEO Ken Lewis. America's new pay tsar (the U.S. Treasury Special Master for Compensation, Kenneth Feinberg) stripped Lewis of his 2009 salary. Don't cry for Lewis just yet. His retirement package will leave him with between US$70 and US$120 million.

But why is there even a pay master to begin with? Isn't that the job of boards of directors and shareholders? Could government charades to regulate the corporate sector get any more cosmetic? Coming soon, a pay master for your job.

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• Stress Testing the Banks
• Aussie Banks are Scrambling to Raise Their Tier 1 Capital Ratios
• Bank for International Settlements Report Looks at Origins of Credit Crisis
• Gold, the Aussie Dollar, the Greenback and You

Nothing broke in the world economy over night. The Aussie market is at a 12-month high. The dollar is marching on the greenback with parity (and beyond) the ultimate objective. But we're going to put all the bullishness from the fake balance sheet recovery aside for a moment and talk about bad medicine.

Your editor spent last night in a discussion with a querulous and drunk Aussie over the stimulus. "It looks like it worked to me," he said. "Only world economy still growing. GDP up. We've got China. Looks like Ruddy and Swanny know what they're doing. You're just a hack. You've never run a country. And you're a Yank!"

"Let me put it to you this way. Say you've got a guy in the hospital with a bad ticker. He's a smoker, a drinker, and a fried chicken eater. His arteries are clogged. He's got a belly like a hippo. He eats like Nero and drinks like Caligula. And say, for the sake of argument, he's gonna die if he doesn't change his nutritional habits. How do you treat him?"

"You tell him to quit being a fat @%$#!"

"Talk therapy. That's good. But let's talk medicine. What do you prescribe? More food? Do you say what I said before? Quick! Get the fat guy more calories."

"I suppose not."

"Of course not. The problem isn't that the guy is starving and needs to be fed. The problem is that his diet is garbage and he needs to change his living habits. But if the doctor diagnoses the problem incorrectly, the medicine isn't going to help at all. And as the Dean says, 'Fat, drunk and stupid is no way to go through life, son."

We'll spare you the rest of the conversation. But here is our diagnosis of the Australian body politic: Wayne Swann is a bad doctor. His Keynesian prescription for the Australian economy is based on the assumption that aggregate demand must be supported in recession. But then, the Keynesian approach to monetary policy focuses on demand, not on production.

Don't take our word for it. Swanny said over the weekend, that "Weakness in hours worked remains a potent sign of insufficient aggregate demand in the economy." This is why, he says, it's too early to take away the stimulus. "To entirely remove the fiscal support from the economy at once, would reduce growth by 2 per cent in 2010. That would risk stalling growth in our economy before a self-sustaining recovery in private activity has taken hold."

Would it be so bad to lose a few pounds? Would it be so bad to reduce the amount of debt that supports toxic levels of consumption? Would it be so bad to let people build up their savings, reduce consumption, and restore the health of the household balance sheet? Or must we keep them fat, drunk and stupid at all costs?

Australian taxpayers are going to pay for today's deficits for years on end because the Treasurer and the Prime Minister (and apparently everyone in the opposition too) is using a flawed theory on how to manage an economy during a recession. The Treasurer would have been better off thanking China for restocking its commodity inventories and left it at that.

But there are votes to buy! Supporting "aggregate demand" or firms that are "too big to fail" is another way of saying you must reward those who contribute to your campaigns or whose votes you need to keep you in power and in your privileged position. From an investment perspective, the relevant question is which industries benefit (or lose) the most from the government siphoning off money from the private sector and direct it whichever way it chooses.

Obviously bankers and builders will do well. What about everyone else? It's tough to say. But you could be forgiven if you think that the ultimate objective of all this is to put average Aussies deeper in debt (housing and credit cards) and more in thrall to their banking overlords.

By the way, this is how governments pick winners (banks) and force everyone else to speculate. The injection of cash into the economy distorts asset values and makes good old securities analysis (Graham and Dodd style) useless. The free money and relatively low cost of capital favour the speculators over the investors, turning the stock market from a weighing machine into a one-armed bandit.

There is only one hitch in the plan for the public sector to replace the private sector as the main source of spending, though. The banks may refuse to play their part in peddling new money. Remember, the transmission of the credit crisis from the financial sector to the real economy took place via the banks. When the banks faced credit write downs, they cut off the extension of credit to small businesses and some households (although the government continues to underwrite speculative mortgage origination through subsidising non-bank lenders).

The stimulus and the FHOG were one quick way to get money directly into the hands of Australians without directly involving the banks. That's why it led to an increase in GDP (which measures economic busyness rather than real value creation). But if the banks are still tight with credit (excepting the housing market) how else can the government keep people spending money they don't have?

This may not be as big a problem here in Australia since there is now a minor disagreement between the Government and the Reserve Bank. But here's a prediction: look for national governments to becoming increasingly creative (and brazen) in given direct handouts to people in order to "support aggregate demand." The government will become a direct lender (through tax credits or the outright nationalisation of things like housing and auto finance).

Figuring out your investment strategy in this climate is tricky. But it's not anything new. The late Harry Browne used to say that markets go in cycles from Propserity to Inflation to Deflation to Recession. Harry recommended a basic asset allocation strategy that matched the right asset class with the right cycle. You changed your weightings between stocks, bonds, real estate, and gold depending on which cycle you were in.

In "The Fourth Turning," authors William Strauss and Neil Howe tell us that history is worth studying. "The reward of the historian is to locate patterns that recur over time and to discover the natural rhythms of social experience. In fact, the core of modern history lies in this remarkable pattern: Over the past five centuries, Anglo-American society has entered a new era - a new turning every two decades or so."

"At the start of each turning, people change how they feel about themselves, the culture, the nation, and the future. Turnings come in cycles of four. Each cycle spans the length of a long human life, roughly eighty to one hundred years, a unit of time the ancients called the saeculum. Together, the four turnings of the saeculum comprise history's seasonal rhythm of growth, maturation, entropy, and destruction."

We'll have more on the turnings tomorrow and how Australia might be in a different season than America. Actually, that's already true. Its spring here and late fall there. But the historical question is whether Australia's economy and its future are now correlated to Asia and not "Anglo-American society." This has massive implications for the economy, but also how Australians feel about themselves, "the culture, the nation, and the future."

Dan Denning
for The Daily Reckoning Australia

• The Drunk at the Dentist Office
• How Much Worse Can the Stock Market Get? A Lot Worse
• Fed Vice Donald Kohn Urges Emerging Markets to Drop the Dollar Peg
• Government Debt
• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End

..where earnest men and women toil long hours in glass towers. What are they doing?

'Look at this chart,' they tell clients. 'It shows how much you can expect to make at different risk levels. And see this curve? It is what we call the 'efficient frontier,' where the risk/reward relationship is optimized by proper asset allocation.'

'Wow,' you say. 'You must have some pretty smart cookies working for you.'

'Well, we do our best,' says the young man, modestly.

In a normal economy, 'finance' performs a useful function - helping to match up people who have capital with people who need it. But even when it is on the level, the profession is full of bombast and flimflam.

Those numbers, presented so confidently to customers, were 9/10ths smoke and 1/10th mirror. The new book by Rogoff and Reinhart confirms a point made by our friend Nassim Taleb: both the theory and practice of modern portfolio analysis were flawed. The theory was flawed because people are not reliable. They don't always react in the way their models predict. What they did in the past may or may not be what they do in the future. And the practice was flawed because the past that the number crunchers looked at was limited to the last 25 years; it was the period since 1980, for which they had the figures! In other words, their models were based on numbers only from the boom years.

The US dollar is getting trashed, Strategic Short Report's Dan Amoss tells us.

The greenback "is increasingly being viewed as a 'funding' currency in the carry trade," Dan continues.

"In other words, leveraged speculators are borrowing US dollars in the short-term money markets at near-zero rates to buy bonds in higher- yielding currencies like the Australian dollar or the euro. If this trend remains in place, it will continue to drive down the exchange rate of the US dollar, and drive demand for gold up.

"This trashing of the dollar is not bullish for America as a whole. It's dangerous for the viability of the middle class. It's good for exporters of agricultural products, specialized manufactured products, and energy producers, but bad for everyone who pays for lots of imported products, or imports that are incorporated into the supply chains of businesses that sell to US consumers.

"I think this claim that 'a weak dollar is good for exports' is narrow- minded and misleading. It ignores the fact that a weak dollar would drive capital out of the US, into economies that are paying a real return on their currencies."

Bill Bonner
for The Daily Reckoning Australia

• A Dollar Crash Will Have Disastrous Implications for Global Financial Markets
• The U.S. Dollar vs Inflation, Americans Vote for the Dollar
• U.S. Dollar Strength or Oil Weakness?
• The US Dollar Showing Signs of Life
• Gold, the Dollar and Inflation

"We may now be entering the Asian century, dominated by a rising China and its currency. This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable."

Yes, it could take more than a decade. But investors could take a big loss any day. All it would take would be a sudden move by China...or a shocking inflation figure in the United States...or a Treasury bond auction that doesn't go as planned. Everyone is watching the United States...carefully. And foreigners hold trillions' worth of dollar- based assets outside the United States. These are dollars that people hold, not to pay their bills or buy gasoline, but as a speculation. They're speculating the greenback will hold its value as well or better than the other things they might do with their money.

Europeans hedge their bets against the euro - with dollars. Asians hedge their bets against falling stock prices. Russians hedge their bets against the ruble. Latin Americans hedge their bets against their own pesos, bolivars, and cordobas. Everybody likes dollars because they are the most trusted money in the world. For the last 50 years, nothing could compete with the dollar. (Even though the dollar lost value against a number of other currencies over long periods of time.)

These foreign holders are already nervous. They've seen the mess the United States has gotten itself into. They read the headlines. They watch the news. They know that the United States is running a budget deficit this year equal to four times the biggest budget deficit ever - a record set just last year. It is as if a runner broke the record in the 100-yard dash...and then ran the course four times faster a year later. This is not progress. This is spooky.

The Chinese already let the United States know they are worried.

"We trust you to protect the value of our assets," they in essence said to the US Treasury Secretary.

And in the middle of May 2009, from the Financial Times comes news that Brazil and China are working toward using their own currencies in trade transactions rather than the US dollar.

This comes on the heels of the news that China's central bank governor Zhou Xiaochuan proposed to create a reserve currency "that is disconnected from individual nations."

What Mr. Zhou would like is to replace the US dollar as the world's leading currency with a new international reserve currency, possibly in the form of special drawing rights (SDRs), a unit of account used by the International Monetary Fund.

Then in June, Russian President Dmitry Medvedev questioned the US dollar's future as a global reserve currency and said using a mix of regional currencies would make the world economy more stable. Russia may consider ruble-yuan swaps.

The dollar "is not in a spectacular position, let's be frank, and its prospects cause various questions as do the prospects for the global currency system, " Medvedev said in an interview published by the Moscow-based Kommersant newspaper. Regarding the global financial system, "therefore our task is to make it more mobile and at the same time more balanced."

But for now, as long as these countries trust the United States to keep its promises and protect its money, they continue to hold US dollar investments - notably, US Treasury bonds. But just wait until the United States loses their trust. In a matter of minutes, China could dump enough US dollars to set off alarms all over the world. All of a sudden, dollar holders would rush for the exits - each one trying to get out before the others. In minutes, the dollar market could collapse...taking down US Treasury bonds with it.

Regards,

Bill Bonner and Addison Wiggin
for The Daily Reckoning Australia

• The Greenback Dollar Decline
• US Dollar As Reserve Currency Not Working Very Well
• US Dollar a Sort of Monetary Brand
• 4 Ways to Protect Against a Falling Dollar
• Special Drawing Rights Used as the World’s Reserve Currency?