For proof of the first claim - that excessive leverage and too much debt cost Australian investors billion of dollars - read today's essay "Pigs at the Trough" by guest essayist Adam Schwab. Adam's got a new book out by the same name. And he makes a great point: Australia may not have learned much from the first round of the GFC.

But is there really going to be a round two? Well, if the first incorrect assumption was that Australia didn't have a bad debt problem, the second assumption is probably even more dangerous. It's more dangerous because it's the single most unexamined assumption behind much of Australia's economic prosperity. The assumption is that we'll always have China.

A growing number of professional investors are betting against China. It's true that all of these investors - short-seller Jim Chanos, our friend Dr. Marc Faber, Harvard Professor Ken Rogoff - are all talking their book to some extent. We all do that all the time. But that doesn't invalidate our arguments.

And the argument is simple: China's economy is the Greatest Bubble on Earth. James Rickards, the former General Counsel for the famously-failed hedge fund Long-Term Capital Management, told Bloomberg that China is in the midst of "the greatest bubble in history." He said the Chinese central bank's balance sheet, "resembles that of a hedge fund buying dollars and short-selling the yuan." "As I see it, it is the greatest bubble in history with the most massive misallocation of wealth," he told the Asset Allocation Summit Asia 2010.

Students of the Austrian School of Economics would identify with the comment. Credit bubbles - and the world has arguably been in one long once since the U.S. dollar could no longer be redeemed for gold internationally in 1971 - know that credit creates excess demand. It gives producers a false impression of the consumer appetite for goods and services. Real resources are poured into providing people with products they buy with debt-based money.

When the bubble bursts, the demand goes too. This is why Australia's government, slavishly obeying Keynesian dogma, has tried to "bring demand forward" or "support aggregate demand"
by giving away the nation's surplus. And once it was finished doing that, it borrowed (stole) from the future in order to support demand.

But this just perpetuates the misallocation of resources (in this case, stealing tomorrow's savings to support today's consumption.) In China's case, however, the misallocation of resources is even more impressive. There is massive over-capacity in commercial real estate with millions of square meters of vacancies. Whole cities lie empty.

These cities and office buildings were made with Australian iron ore and coking coal. If China's miracle economy (regularly achieving politically mandated 8% GDP growth to support employment) is really the world's largest collection of misallocated resources ever, then what do you think will happen to Australia's economy?

On the verge of another big increase in contract iron ore prices, it may seem like a strange time to ask the question. But it's probably the most important question Australian investors could ask themselves this year. "What can I do to protect myself against a crash in China?"

The possibility may seem remote. But remember, no one in the mainstream media or economics profession warned you of the GFC either, did they? Even if you think it's unlikely or absurd, it's probably something you should think about a bit. We've thought about it and we think the best answer is to retire now.

But what does that really mean? It means you should own a lot fewer stocks. But yes, that does contradict the rosy projections for Australia's super annuation system. Australia's super system is projected to have nearly $5 trillion in assets by 2025 according to an article in today's Australian.

Chris Bowen, the Minister of Financial Services, spoke by video to a conference in Brisbane. He didn't say where all the super money would go specifically. But he did say, "This might mean greater investment in infrastructure assets, provided a stable pipeline of opportunities was available."

Now you may want your money to go into infrastructure assets. And if you do, more power to you. After all, they are tangible assets. But you can't put a bridge in your refrigerator. Portable tangibility - wealth you can wear, store, or trade - is the name of the game as you reduce your allocation to deflating financial assets ahead of the hyperinflation. More on that Big Crash two-step in Friday's letter.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The ASX Bubble, Fueled by China
• Building a National Economy Around the Housing Industry
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• The Price of Oil is in a Bubble

China has quietly bought stakes in America's leading companies...and in various businesses all over the world. But the only way large amounts of US dollar cash can be readily and safely deployed is in US bonds.

That said, China could also cause one helluva problem for the US if it ever chose to do anything else.

No worries on that score, said the Chinese official in charge of its $2.4 trillion worth of foreign reserves. He says China's holdings of US debt are normal and that there is no intention of reducing them or playing politics with them.

He surely means it. And when the dollar goes down...and when the market turns, and China feels compelled to get rid of its US bonds, he'll be totally sincere when he explains that to the international financial press too.

Markets make opinions, as they say on Wall Street. The market in bonds and the dollar has been very good for a very long time - since 1983, to be exact. As a result nearly everyone - including the Chinese - are of the opinion that US bonds are a safe place to be. When the market changes, so will opinions.

So far, no problem. But there's no telling how long the foreigners will continue to support the dollar. Then what? Well...it leaves quantitative easing...in which the US central bank lends the money itself. Where does it get the money? It just invents it.

Which is why you can't trust paper money. You have a dollar. You have it. You hold it. And you expect to keep it 'til death do you part. But then, along comes another dollar that looks just like it...fresh...young...full of vim and vigor. So why not? Everybody does it.

Pretty soon, there are a lot more dollars running around. And they change hands fast. In economists' lingo, the velocity of money goes up...and the value of the dollar - like a faithless lover - goes down.

Bill Bonner
for The Daily Reckoning Australia

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• China Reduces Holdings of Treasury Securities
• Fannie and Freddie in a Free Market Economy
• China is a Key Driving Force in the Gold Market
• China Stepping Up Purchases of U.S. Treasury Debt

If that's not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we're wading through. So we'll do our best to clear them up for you. But it's probably going to take two days. Today, we'll look at the case against deflation. Tomorrow, we'll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we'll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He's written about it for years. But for a short course on what he's predicting and why, check out this video.

In the video Prechter says, "The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back....The scramble will be for dollars not for things."

The investment outcome of Prechter's scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, "the chances of default are low." Prechter's argument is based on the idea - which we happen to believe - that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter's reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that's trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren't unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that's not in anyone's model might be the sort of thing that precipitates the next crisis. After all, that's the way these things generally begin.

You could make the argument that it shouldn't really matter to the real economy if a bunch of global institutions find out they can't settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can't we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today's funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are "danger" banks. The reason is that these banks own mostly commercial real estate. It's their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren't going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We're going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It's easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it's hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people's preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We'll assume for the moment the regular banks won't do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit...to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it's monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can't have inflation if there's no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won't this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we're going out on a limb. But what we're arguing is that as the private sector is less able or willing to dole out credit into the economy, we're entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It's done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won't do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it's possible to receive 99 weeks of unemployment benefits. This doesn't mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments...well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it's true for the Euro, the Yen, and the Dollar. It's true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed's ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar...mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you'll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and "jobs" programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it's possible - likely even - that you're going to see across the board falls in stocks, real estate, bonds, and commodities....AND inflation. Whether we got the proper sequence right, we're not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

• Credit Markets Threaten Retail Banking, Bank Runs Next?
• Nationalised Banking System Will Come from Global Market Rout
• Bankers Take Money From the Government and Use it to Speculate
• The Single Best Trade for 2010
• World Economy Faces Hyperinflation or Deflation?

To understand what's taking place in China today, we need to rewind the clock about a decade. At that time the Chinese government chose a policy of growth at any cost. To achieve that, it kept its currency (the renminbi) at artificially low levels against the dollar -- this helped already cheap Chinese-made goods become even cheaper than its competitors'. The US and global consumers were eager to buy them. China turned into a significant exporter to the US. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, if China let its currency appreciate, its exports would have become more expensive and the demand for Chinese products would have declined, and its economy wouldn't have grown at 10% a year.

But China isn't your local democracy, and it needed to grow at any cost. So instead, through the government-controlled banking system, China accumulated a couple trillion dollars of foreign reserves in US dollars and euros. This had an unintended consequence: It helped keep US interest rates at very low levels, and lent a friendly hand in the financing of a huge consumption binge by the US consumer (i.e., China's largest customer).

The more China sold to the US, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. The US consumer was in turn happy to leverage its future (through the "always" appreciating asset, its home) and delighted to consume cheap Chinese-made goods.

This symbiotic match made in heaven between China and the US consumer worked great as long as housing prices kept rising and the financial machine kept multiplying dollars. But all good things come to an end, and great things come to an end with a bang. The financial meltdown erupted upon us and, well, you know how that story played out.

So now let's fast-forward a year. Today the global economy is stabilizing. But the US consumers of Chinese-made goods are now deleveraging, unemployment is high, US banks aren't lending.

Despite this, the Chinese export-based economy has clocked growth of 8.7% in 2009. The rest of the world looks at the Chinese growth miracle with envy; it seems that China has got economics figured out. But don't hurry to trade your democracy for an authoritarian system. The Chinese grass is not as green as it appears.

First, one shouldn't believe all the economic numbers that are put out by the Chinese government. This is the government that magically managed to report 6% to 8% GDP growth in the midst of the financial crisis, when its exports were down more than 25%, tonnage of goods shipped through its railroads was down by double digits, and its electricity consumption was falling like a rock.

Second, China will do anything to grow its economy, as the alternatives will lead to political unrest. A lot of peasants moved to the cities in search of higher-paying jobs during the go-go times. Because China lacks the social safety net of the developed world, unemployed people aren't just inconvenienced by the loss of their jobs, they starve (this explains the high savings rate in China) and hungry people don't complain, they riot. Once you look at what's taking place in the Chinese economy through that lens, the decisions of its leaders start making sense, or at least become understandable.

Unlike Western democracies, where central banks can pump a lot of money into the financial system but can't force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The Chinese government controls the banks, thus it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, China can spend infrastructure project money very fast -- if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good.

China has spent a tremendous amount of money on infrastructure over the last decade and there are definitely long-term benefits to having better highways, fast railroads, more hospitals, etc. But government is horrible at allocating large amounts of capital, especially at the speed it was done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.

Infrastructure and real estate projects are where you get your biggest bang for the buck if your goal is to maintain employment, because they require a lot of unskilled labor; and this is where in the past a lot of Chinese money was spent. This also explains why the Chinese keep building skyscrapers even though the adjacent ones are still vacant.

Though Chinese economic growth in the past was very high, more recently the quality of growth has been low. For example, in an echo of past Chinese government asset-allocation decisions, China built the largest shopping mall in the world, the South China Mall, which is still 99% vacant years after construction. China also built a whole city, Ordos, in Inner Mongolia, on spec for one million residents who never appeared.

The inefficiencies are also evident in industrial overcapacity. According to Pivot Capital, Chinese excess capacity in cement is greater than the consumption of the US, Japan, and India combined. Also, Chinese idle production of steel is greater than the production capacity of Japan and South Korea combined. Similarly disturbing statistics are true for many other industrial commodities. The enormous stimulus amplified problems that already existed to financial-crisis levels. China is a less shiny but more drastic version of Dubai.

There is speculation that the Chinese consumer will pick up the demand slack for the US and European consumers who are deleveraging and buying fewer Chinese-made goods. This may happen, but it will take decades. The US and European consumers are two-thirds of much larger economies. The Chinese consumer is only one-third of the Chinese economy.

We look at China and are mesmerized by its 1.3 billion people, its achievements of the last decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. This was the case with railroads in the US in the late 19th century: The railroads were supposed to change the landscape of the US, and they did, but that didn't prevent a lot of them from going out of business first. The Internet was supposed to change how we communicate, and it did, but in the process it generated a tremendous bubble, followed by the loss of wealth for many. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we've got a bubble on our hands.

Everyone wants a shortcut to greatness, but there isn't one. It would be great if the word (economic) cycle only existed in a singular form, and the only cycle we had in the economy was happy expansion. If there were no cycles, there would be no painful recessions. But as heaven couldn't exist without hell, or capitalism without failure, economic expansion can't exist without recession. China has been trying to bend the laws of economics for awhile, and with the control it exerts over its economy it may seem, at least for a short while, that the laws of economics work differently in China. But this is only a temporary mirage, which must be followed by huge pain and drastic consequences. No, there's no shortcut to greatness - not in politics, not in personal life, and certainly not in economics.

Regards,

Vitaliy N. Katsenelson
for The Daily Reckoning Australia

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• China, the Miracle Economy
• Total Implosion of the Chinese Economy
• Chinese Economy Seems to be Growing
• The New Chinese Era

But first we have to deal with the Fed. As you know by now, it raised the discount rate - the rate at which the Fed charges banks to borrow from it - by 25 basis points to a whopping 0.75%. Markets took this as a sign that the Fed is tightening monetary policy and beginning its 'exit strategy' from quantitative easing. The dollar rallied (more on that below).

Not so fast! The Fed made clear that it was raising the discount rate in order to encourage banks to borrow from one another and not the Fed. It wants the banks to play nice instead of doing business at the discount window. And it explicitly said it is not raising rates as part of a "tighter" monetary policy.

To be exact, the Fed statement read, "The modifications [to the discount rate] are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy." Pretty clear there, isn't it?

Of course the Fed could be saying one thing and meaning another. But what it says and what the market hears can be different anyway. And the market seems to think the Fed's move supports the dollar. The bullish move in the dollar was crystallised by what traders call a "golden cross." See below.

Click US Dollar Index chart to enlarge

It's a bit ironic a bullish move on the dollar index is called a "golden cross." But what to the traders mean? A "golden cross" is when a 50-day moving average crosses up against a 200-day moving average, which is also on the way up. It's doubly bullish, with an extra kick of momentum. But does the Fed's small increase in the discount rate really account for this?

We'll answer that in just one second. But when we asked Murray this morning whether the crossing of the 50 and 200 day moving averages was a big a deal as the headlines said, he said it wasn't as useful indicator as the crossing of the 10-day and 35-day moving averages he uses. And then he sent us the chart below and told us that if the dollar index breaks through 79 (it's at 80 as we speak), to look out for 84 as the next resistance.

Click Slipstream Trader chart to zoom in

On Murray's chart, the blue line is the 10-day MA and the red line is the 35-day MA. The 84 level he mentions corresponds to the middle of the dollar indexes' price distribution (the overlaid lines). This is exactly the same type of analysis Murray uses to generate trading ideas. And the dollar's move is meaningful, given he has several long gold positions at the moment. We'll let you know how those go.

But back to the key question: does the dollar's strength come from the Fed's move to raise the discount rate? Is this an "all clear" that worst of the crisis is behind us?

Definitely not. The dollar's fundamental strength is not improved by a quarter point hike in the rate which the Fed charges banks to borrow. The annual fiscal deficit in the U.S. is in double digits as a percentage of GDP. The Congress is gridlocked. Many of the U.S. states are going bankrupt. And as Albert Edwards showed this week, the U.S. is insolvent.

None of those facts argue for a stronger dollar. But one thing DOES argue for a stronger dollar and that thing is this: the U.S. dollar is not the Euro.

In other words, the currency markets are telling us that the Euro's ambitions as a global reserve currency may be dead. As an experiment in a managed currency designed to rival the dollar, it's failed. Greece may be the proximate cause. But the design of the euro itself - one monetary policy to go with many fiscal policies (and fiscal deficits)- was the first cause.

As the main rival (amongst paper currencies) to the dollar as a global reserve currency, the euro's coming collapse has to, almost by definition, equal dollar strength. There just aren't that many more liquid alternatives for large institutions and central banks. They can diversify amongst higher yielding currencies and tangible assets. But the massive liquidity offered by short-term U.S. government debt markets is too easy to resist.

So everyone is piling into the dollar as a paper money lifeboat. The dollar's inherited status as reserve currency has trumped (for now) the fiscal and monetary mismanagement of the U.S. political establishment. We think this makes now a very good time to buy gold.

Of course it might not see that way given that the gold price fell sixteen dollars in New York trading to $1,102. The superficially bearish news is that the IMF wants to complete the gold sale it announced last year by selling another 191 metric tonnes from its inventory.

Remember last year the IMF announced it would sell 403 metric tonnes of gold. The first 200 tonnes were sold, in a bit of surprise, to the Reserve Bank of India. The conventional wisdom had pegged China as the likely buyer.

Selling the remaining 191 tonnes would reduce the IMFs holdings by just one eighth. It would still be the third largest holder of gold reserves behind the United States and Germany. But is this bearish news for gold? Will there be any buyers? With the greenback rallying, will gold suffer from a supply dump on the open market via the IMF and a rampaging dollar index?

We'll see. But we'd guess that gold's going to be just fine. Just remember that all three buyers of the IMF's last gold sale were central banks. The Central Bank of Mauritius bought two tonnes and the Central Bank of Sri Lanka bought ten tonnes. Central banks are still really the only institutions in the world that hold gold as a real monetary reserve.

Our guess - and we should make clear it's just a guess - is that the IMF announcement will work out nicely for some central bank somewhere. The announcement will push the price of gold down temporarily, allowing a central bank to add to its gold reserves at a lower average price. But why would central banks be loading up on gold?

Well, if they're unloading the euro and, in China at least, the U.S. dollar, they have to load up on something more tangible. So perhaps someone is twisting the IMF's arm to sell more of its gold so certain sovereign nations are in a better position to survive in the event of sovereign debt default by one or several European States.

But we'll make it simple for you. We're headed back to the States next week for a quick trip and our intention is to sell the dollar on strength and buy gold. We'll tell you how later.

For the moment, none of this major deck-chair scrambling in the global currency markets is affecting Aussie stocks prices. The indexes are up as we right. Reserve Bank Governor Glenn Stevens repeated the view, although these weren't his exact words, that Australia has decoupled from America in the sense that future earnings and economic growth will come from trade with Asia.

That may be true, although we have our doubts. But the other question is whether Australia's financial markets have decoupled from instability and volatility that originate in Europe and America. We suspect they haven't. And for that reason, watch out. It's going to be a crazy year.

Dan Denning
for The Daily Reckoning Australia

• Price of Gold Communicates U.S. Monetary and Fiscal Policy is Lousy
• US Dollar As Reserve Currency Not Working Very Well
• Federal Reserve Wants to Debase the U.S. Dollar
• U.S. Dollar Retreating Against Commodities
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar

Stock markets around the world got the jitters, stumbled and then face planted. And that was just the first two days. Will the mud stick, or will the market get up and go-go-go from here on?

Why not ask Bill Bonner?

"We've had our bounce. Now, we'll take the long slide down to the ultimate, final, this-is-where-it-stops end."

Personally, I don't think sliding is quite the right word. Indexes don't slide around, they get pushed and shoved all over the place.

The strange thing about indices is that they only include the better performing companies. Most indicies have requirements for size or other factors before a company is included. If a company's share price falls enough, it is often deemed too small to be included in the index any longer. Thus, the underperformers aren't included in the index over time. The markets call this survivorship bias.

I call it fraud.

That's because the "buy and hold" strategy the mainstream advocates is based on index returns over time. Buying and holding a diversified portfolio won't necessarily get you the index returns, not that they are favourable in the first case.

If you diversify to the extent that the mainstream suggests, chances are that you will pick a lemon. It would only take one such lemon to make the whole portfolio sour. Meanwhile the index could happily continue on its way up, having dropped the lemon from its basket of companies.

Practice makes Perfect

We now know that world governments are perfectly comfortable with their "whatever it takes" attitude. Nobody else is. The humorous aspect to this is watching fund managers trying to work out where to park your/their money. Every country has a government willing to greet funds with open arms and an interest payment. More and more of those governments are in trouble though.

There has been much hype over ratings downgrades and increasing insurance costs on government bonds. What people are discovering is that there isn't anyone to bailout a government. Well, at least not with real money. Central banks have an infinite supply of funny money waiting to be created from thin air, but we will get to that in a moment.

Did you really think that the risks inherent in the economy simply vanish when the government takes them on? Nope, they're still there. In fact, you the taxpayer has taken them on.

Strangely enough, the government of choice when it comes to parking your money during dangerous times is the American one. Whenever markets tank, the American dollar and its government's bonds seem to surge. Daily Reckoning readers know we consider this to be absurd. The American government is probably worse off than many countries in the long run.

So why does the "flight to dollars" commence each time world equity markets take a step backwards in their weird dance routine? Well, it's all got to do with liquidity.

"The secondary market for U.S. Treasury securities is the most liquid secondary market in the world. The spread between bid and offer prices is usually considerably narrower than other securities, making most Treasury issues easy to purchase and sell. [Emphasis added]"

When you don't know what to do, you try to keep your options open. Treasuries earn small amounts of interest, but are easily convertible to money, even in the large quantities that some funds deal in. This gives even the biggest investor the flexibility to move fast. The thing is that these government bonds probably aren't worth holding on to for very long.

This leads to an incredible opportunity for investors. It's "a no brainer" to sell short Treasuries says Nassim Taleb on Bloomberg. "Every single human being should have that trade." Nassim's ability to forecast the crisis made him and his book "The Black Swan" a household name.

The list of people who agree with him is enormous and includes some big players. But that makes me nervous. If everyone agrees, why has nothing dramatic happened? The answer we venture is that investors don't want to get caught out investing outside of the US, just in case the flight to the dollar occurs again.

However, consider that Bernanke and his fellow counterfeiters have put in some good practice at manipulating markets. They can engineer quite a rally through their policy tools. So how does this play out?

Simply put, the Fed can support bond and other asset prices all day long, but only at the expense of the value of the US dollar. It can print money to buy US government bonds and other assets, but more money means that money is worth less - that's inflation.

The illustrious forecaster of the financial crisis, Peter Schiff, is often misunderstood. I recall a video where he refused to give his prediction for how far stock markets would fall. After much coaxing from the TV host, an answer was finally given, much to the confusion of those watching.

The answer was that the Dow (the index commonly quoted) will be worth "1 ounce of gold". This implies a significant fall in the Dow, or rise in the price of gold. What Schiff means is exactly my point above. The Dow could go anywhere if the value of the dollar changes as well. If the Dow rises by 50%, but the value of the dollar falls by 90%, you still have a whopping loss.

So, why one ounce of gold?

As gold is considered the only real money that has withstood the test of time, it is a better asset to measure the Dow against than any paper currency. Any change in the value of the dollar should occur in the value of gold, thus offsetting the instability of the dollar.

Of course, the value of gold isn't just influenced by inflation, but it remains the asset which has outlasted many other paper currencies. An ounce of gold could buy you a snazzy outfit in Roman times and can still do the same in Rome today. Its value remains. Meanwhile, the Zimbabwe dollar and the Reichsmark don't buy much at all.

Schiff may not only be right in his prediction for the Dow, but he has made it in a way that only savvy investors can understand.

The Ouzo Effect

Another possible kick in the shins for those shorting US government bonds, or the US dollar itself, would be a full blown sovereign debt crisis striking in Europe before the US, creating rally in the "safe" USA.

Nouriel Roubini, another predictor of world economic problems, has been vocal about the possibility of problems in Europe. In fact, he sees the potential for a serious shakeup of European economies: "Down the line, not this year or two years from now, we could have a breakup of the [European] monetary union."

If the UK weren't in as much, or more trouble this would bring delight to their faces. "Sound as a pound" is a favourite saying of one of my friends. Unfortunately, the PIIGS acronym may have to get a lot longer very soon.

"The problems currently faced by peripheral Europe could be a dress rehearsal for what the US and UK may face further down the road" said Jim Reid, a strategist at Deutsche Bank.

We would like to invite readers to submit their suggestion for a new acronym to include the US, UK and any other debt ravaged nations. Sadly, this will mean we won't get to use a bacon analogy going forward.

But your former Daily Reckoning Week in Review editor, Dr Alex Cowie, has pointed out something better than bacon. It's called the "Ouzo effect".

"This is where we see contagion [from Greece] pass across to the other European countries with bad balance sheets like Portugal, Italy and Spain, the so-called 'PIGS'. If this situation plays out slowly, and investors get little reassurance from the 'PIGS', then high risk assets such as mining equities may offer even better buying opportunities in coming weeks."

For the record, Ouzo is a brilliant Greek alcoholic beverage. I would recommend it over mining stocks any day.

The Business of Banking

The Australian government has announced the withdrawal of the wholesale funding guarantee it has provided for some time now. In other words, the banks are going to be on their own... More or less... To some extent...

Let me ask you a simple question. If you were a butcher, baker or candlestick maker and the government decided how many fillet mignon, cupcakes or candles you could sell, how would you feel? What if the government then decided at what price you could sell those items?

Any person operating under those constraints deserves your utmost sympathy, right? It sounds like something out of Stalin's Russia and Mao's China.

There is, in fact, a huge industry in Australia operating under those very constraints. The price it sells its goods/services at and the amount it can sell are largely set by the government. In fact, the industry operates much the same way around the world, under the same or similar crippling circumstances.

Strangely enough, that very same industry has been accused of rampant greedy capitalism and profiteering. Even more surprising is that the regulation applied to the industry isn't even decided on by the government. A private institution, unaccountable to government makes the rules.

What is the industry I'm on about?

You are probably thinking to yourself, "This plonker thinks I didn't read the sub-heading he wrote himself just a few lines ago."

That's right, I'm on about the banks. And not about any new regulations either. I'm talking about business as usual.

Banks sell money in the form of loans. Their price is the interest paid. The regulator known as the central bank sets both the supply of money and the interest rate. Banks can theoretically diverge from this, but competition effectively keeps them pinned down to whatever the central bank deems as appropriate.

In my opinion, there is no industry in the world more regulated than banking. Everyone else I can think of can control the price they sell at and how much they can offer to sell.

Of all the people!

After almost bringing the world economy to its knees and relying on government support to survive, the banks, credit ratings agencies and economists are back to telling the politicians they are stupid. Poor old Barnaby Joyce. Apparently he was being irresponsible by warning of too much debt. Hahaha. It's so ironic in so many ways.

The Labor party considers itself to represent the Aussie battler. Yet the Australian points out that "Swan [is] to resist [a] low-income wage breakout." This comes after the same newspaper reported in 2008 that "Wayne Swan will make it a "top priority" in his first budget to protect low- and middle-income earners, after a study revealed the lowest-paid fared well under his predecessor, Peter Costello." Maybe being a top priority of the government isn't so great.

Meanwhile, the guy who was supposed to warn us of instability in financial markets before his promotion to Treasury Secretary, Tim Geithner, has made himself look ridiculous. Again. He said the U.S. government "will never" lose its triple A credit rating. It is well known that one does not grow up to face reality without leaving "Never Never Land".

China's military has other ideas for the US government's borrowing plans, after being poked in the eye by the sale of US arms to Taiwan.

"Just like two people rowing a boat, if the United States first throws the strokes into chaos, then so must we.... attack by oblique means and stealthy feints... For example, we could sanction them using economic means, such as dumping some U.S. government bonds."

The Chinese government holds about US$ 790 billion of those bonds and a further US$1.95 trillion in US dollar reserves...

Nickolai Hubble
The Daily Reckoning Week in Review

• Price-to-Earnings Ratio of the S&P 500 Index
• CRB Index Correction Likely to Go Further
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• Inflation is Evident If You Just Follow the Money
• Gold is the Only Place to Turn in Times of Inflation

Not that we're easing into the holiday break. Here in the U.S., bond yields are rallying. That means bonds prices are falling. Stocks, the dollar, and commodities are up. Existing home sales were up here in America, but prices continued to fall. There was also a downward revision to third quarter American GDP (originally it was 3.5%, then 2.8% and now 2.5%).

We'll see if that bothers Aussie shares. The miners and the banks drove the ASX/200 up 1.5%. But the U.S. lead today is mixed. Investors are selling bonds. But are they going to turn right around and buy stocks? You gotta do something with all that cash.

Here in the States, we can say that the U.S. dollar is cheap. Everything in America seems cheap compared to Australia. Food, beer, movie tickets, petrol, and of course, houses. The cost of living is definitely lower here, at least in this part of the country. But even though it's had its first monthly rally since June, don't go pinning your hopes on the U.S. dollar.

The major trends defining the world - the migration of wealth from West to East - are still in motion. But right now it looks like plate tectonics, powerful, but underneath the surface. It can lead you into a sense of complacency that nothing is moving at all. Or, it can lead you to send it a note like the one below (reproduced with its original inaccuracy in spelling).

--Dear Dan & Colleagues

Regards John Matheson

Merry Christmas to you too, John. The test of our big ideas here isn't a few months. It's a few years. And what exactly were we wrong about this year? That the Aussie market hasn't collapsed? That shares haven't retested the 2003 lows? Give it time mate.

But it's a fair cop. Will we be right (again) eventually, simply because of the passage of time? That isn't our investment objective. Our objective is to pick the one or two major trends and figure out how to profit from them. Unfortunately, the major trends in today's global economy (deleveraging, contraction) are threats to your wealth, not opportunities.

That's why the main mission in markets like this is to preserve your capital, not take risks with it by listening to the conventional wisdom. But if we were looking for places to dip our toe in the share markets it would be two broad categories: unconventional energy projects and oversold, world-dominating blue-chip value (as our friend Dan Ferris calls global franchises).

In other words, we'd be bottom feeders looking for a chance to build a small core portfolio of blue chip shares for the next 15 years. But our main preference is stay liquid and tangible, which means more cash than shares and more bullion than bonds.

If inflation picks up in 2010 (because of lending growth by banks) then we might even look to trade depreciating cash for real estate...but land...and not existing housing stock. Houses are cheap in America again - but getting cheaper. Now may not be the best entry price.

Of course nobody knows what will happen. We just know what has happened in the past when credit bubbles have collapsed. Some evaporate quickly and the economy returns to a normal growth path. When the needed correction is drawn out, as this one is, the distortions persist and investors do it even tougher.

So stay tuned in 2010 John. At the very least, reading the Daily Reckoning will give you the enjoyable sensation of being superior. And more positively, maybe you'll even learn something about preparing for the unexpected. But we're not betting any money on it.

Dan Denning
for The Daily Reckoning Australia

• The Only Thing Really Going Down Right Now is the U.S. Dollar
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• U.S. Dollar Index Showing All Sorts of Weakness
• U.S. Dollar Retreating Against Commodities
• A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

• U.S. Dollar Bulls Rallying Behind Fed Statement
• The Trouble With a Sovereign Debt Crisis
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Gold Ratios: Bearish for Gold Prices, Bullish for Gold Shares
• U.S. Dollar Strength or Oil Weakness?

It is not April Fool's day. Federal Reserve Chairman Ben Bernanke is Time magazine's man of the year. Good on ya Ben! But beware the curse.

On February 15th 1999, Alan Greenspan, Larry Summers, and Robert Rubin made the cover of the same rag with the audacious tag, "The Committee to save the world....the inside story of how the Three Marketeers have prevented global economic meltdown...so far."

It turned out that "so far" would last about another year. As you can see from the chart below, the S&P 500 peaked in March of 2000, and then crashed. It wouldn't reach another new high until July of 2007 - right about the time a couple of leveraged funds from Bear Stearns stuffed to the gills with CDOs started to shake the financial system to its foundations.

Click to enlarge

The world doesn't look very saved, does it? Judging by today's Fed statement the world needs more saving. The Fed didn't change rates. But it didn't say when it would remove its support for the housing market (via purchases of mortgage-backed securities) or when it would wind down its other programs that support the fragile state of credit in the American market.

The truth is the Fed can't remove that support yet - or the cost of housing finance would rise in the States. But it may rise anyway. The spread between two-year U.S. Treasury notes and 10-year notes is widening. Thirty-year mortgage rates in the U.S. are tied to the 10-year note. Higher ten-year yields drive up new mortgage and mortgage refinance rates in the States.

Double plus ungood.

By the way, not that we're a bond sleuth, but we read in the Wall Street Journal earlier this week that the spread between 2-year notes and 30-year U.S. bonds is as wide as it has been at any time since 1980. It's the yield curve. So what does it mean that the U.S. yield curve is so steep?

We reckon it means that investors want to be paid more to lend money long-term. This means they fear inflation. They're happy to load into shorter-term notes and bonds. But loan the U.S. government - a government Barack Obama says will go bankrupt if health care costs are not restrained - for 30 years? Fugeddaboutit!

Note that Obama did not say what Senator Barnaby Joyce has said, that America could default on its debt. You have to applaud the Senator for uncharacteristic candour, as far as politicians. Technically, he's probably not quite correct though.

The U.S. government sells debt in dollars. It also prints dollars. That means it can print new dollars to pay off its debt. It needn't default, i.e. be unable to find currency to pay its creditors. If it were issuing debt in a foreign currency, say Yuan, then it would have to pay debt off in that currency and COULD default.

But perhaps we are quibbling over details. An inability to service its debt or pay off its long-term obligations, or just a willingness to do so by printing more money, is effectively a devaluation of the U.S. dollar. That's what the currency markets have been telling us all year. And that's one reason why the yield curve is starting to look like an Olympic ski jump.

This fear of the sustainability of the U.S. deficits is another reason investors and people who use their brain own at least some gold. And on that subject, we copped it a bit from a friend last night for our comments yesterday. He also trotted out a famous quote about gold from Warren Buffett.

"Don't you think you were a bit self indulgent yesterday going after Pascoe?"

"No."

"Well, it is a fair point."

"What is?"

"If the world goes to hell like you say, you can't eat gold. You can't sleep on it, although you could sleep with it I suppose. How useful is it really going to be as a medium of exchange or a store of value if economic activity grinds to a halt?"

"I don't know. I'm not Nostradamus. But I'm not recommending people convert all their equity holdings into precious metals either. I AM recommending they own some bullion and, for leverage purposes, some gold shares. That doesn't seem so radical. Why would anyone find the idea of hedging your bets against monetary policy so kooky?"

"Because monetary and fiscal policy have basically worked, at least here in Australia."

"Are you drunk?"

"I'm serious. The stimulus worked. It kept Australia out of recession. What more do you want?"

"Less. Less is more mate. The stimulus increased the debt and maintained the appearance of growth. But the economy didn't need growth. It needed to reduce personal debt levels and consumption and get a less leveraged balance sheet. The government encouraged the exact opposite."

"Blah blah blah. Even Buffett thinks you're wrong about gold. What's that quote of his... 'Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.' What do you say to that?"

"Buffet is a better investor than I'll ever be. And obviously he's a smart guy. But surely he's heard of Gresham's Law."

"Huh?"

"Gresham's Law. Bad money drives out good. Or to quote the late, great Harry Browne, 'If an individual holds two types of money of unequal value, he will spend the bad money and save the good money.'"

"I'm afraid I'm not following you."

"That's because you're a moron. But it's the argument between owning all paper and at least some gold. You don't convert all of your wealth to gold because right now, that's not useful. You need cash to conduct transactions in the real economy. And when the government is inflating away systematically, it makes absolute sense to get rid of cash before its purchasing power diminishes. Trade it for tangible goods that DO have value or utility like whiskey, cigars, and bullets."

"How about something less revolutionary like houses? "

"Maybe not a bad idea if you're using cash and not debt. And it would be a good idea if the price of the asset wasn't going to collapse imminently. You don't want to convert your cash into a capital asset that rapidly depreciates in value, which is possible with house prices."

"But isn't that possible with gold too? You convert your cash into a tangible asset whose value fluctuates? And it doesn't even pay a yield! And you can't exactly live in it either."

"Of course that's all true. But the reason central banks and households own gold, and the reason people have hoarded it for thousands of years, is that they KNOW intuitively that gold is good money, sound money, and that paper money is generally not good money - especially when it's being actively destroyed by bad fiscal and monetary policy. Generally it's not something you have to consciously think about. Most of the time the money in your pocket is exchangeable for the things you want."

"So what's the problem?"

"The problem now is that people are beginning to understand that monetary inflation is theft. If you trade your labour for wages paid in the form of cash, and the government devalues that cash, it's stealing your productivity. It's trading its paper product for the fruits of your labour at a discount. It's cheating you. Gold doesn't cheat you. It doesn't love you either. It doesn't do anything. That's why people prefer to hold some of their wealth in that form, for those times when they are being cheated by government."

"Well, that's pretty much all the time isn't it?"

"You know what H.L. Mencken said about elections in democracies? He said they are an advanced auction of stolen goods. There's a whole lot of stealing going on these days. A fiat money system is systematic theft because it's based on unsound money. That's what's being exposed by this financial crisis. The entire funding model of the fiscal welfare state is collapsing because it's based on debt and fraudulent, counterfeit money."

"Hey do you want to go see Avatar?"

"Yes!

We're not saying people who don't understand gold's role as money are stupid - although maybe a few of them definitely ARE stupid. What we are saying is that it's not rational to hedge against what you don't know is coming. Most people have no experience with a currency collapse. So they don't prepare for it. It seems so unlikely that it's not worth hedging against.

Incidentally, until we start hearing this conversation in barber shops, we won't be convinced gold is in a bubble. But in the meantime, if you are less dogmatic, a strategy for converting your equity holdings to something more tangible is just as practical.

For example, earlier this week we mentioned ExxonMobil's big natural gas play in the U.S. This matches a theme we laid out earlier in the year at Diggers and Drillers that unconventional natural gas plays - gas from shale formations - would be the next intelligent speculation in Australian energy shares.

That's a classic case of substitution. The high oil price makes other energy alternatives economically realistic. They can stand in as substitutes for the fuel we get from oil (most of the time). This is what Michael Pascoe correctly pointed out when he said we can "make more" of the stuff.

Unfortunately for Ben Bernanke, the Fed can only make more dollars, not more gold. There are not many ready substitutes for precious metals. That's part of what gives them their inherent value; their scarcity. Gold is not exactly unobtainable, like the unobtanium in Cameron's Avatar. But it's certainly getting a lot more desirable the more sovereign states go into debt they can never repay.

Dan Denning
for The Daily Reckoning Australia

• European Governments of the Eurozone are Separately Responsible for Their Euro-debt
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Federal Reserve Wants to Debase the U.S. Dollar
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis
• Inflation: Ron Paul Explains How We Got Into This Mess

The 10 day/35 day moving average has just crossed over and the steady downtrend of the past 6 months has been breached.

If you have a look at the chart you can see that I have marked out the range from late 2008 to early 2009. This range was between 79 and 90 and I believe that range still has an influence over current price action as strange as that may seem.

Click to enlarge

The bottom dotted line is calculated as 50% of the above range below the low of the range. Most false breaks that occur will usually be contained within this area as I have said in the past. The current rally could easily turn into a fake out and it is by no means certain at the moment that this rally is going to turn into a change of longer term trend, but the signs are there that we should keep a closer eye on the price action in the US Dollar in the coming weeks to gain an insight into the direction of overall markets.

More than at any time in recent memory, the US Dollar has become the lynchpin in the direction in nearly all markets. The US Dollar carry trade is funding most of the speculation worldwide so it is imperative that we understand what the immediate future of the US Dollar is if we are to make money over the next year or so.

The US Fed has indicated that they are on hold with their interest rates for the foreseeable future. This has been taken by the markets to mean that most of 2010 will see steady and very low interest rates in the US. This means that it is open season for the banks and whoever else has access to the very cheap funding until the Fed comes out and says otherwise.

As a result we should expect the long term downtrend of the US Dollar to remain in place over the next year or so until there is confirmation that their interest rates will rise.

This does not mean however that we will not see sharp short squeezes which can be vicious and very expensive if you are caught off guard.

Both gold and oil have been taken down in the last few weeks as the US dollar has rallied and we could expect that to continue until the dollar falls over again.

The key area to focus on is the low of last year's range which is 79. This will act as fairly strong resistance on the way up and it would be an area where we could see the dollar reinitiate its down trend. If the dollar was to break this level and re-enter last year's range then we could see a strong and sharp rally to the midpoint or Point of control of the range which is 84. A move such as this would really put the cat amongst the pigeons and would see a large correction in markets worldwide.

It is not until we are above 79 that I would be willing to call a change in the intermediate trend, until then this rally can easily fall over.

Murray Dawes
Editor, Slipstream Trader
for The Daily Reckoning Australia

• S&P 500 Heading Towards Some Major Long Term Resistance Levels
• The Aussie Dollar as a Measure of Global Risk Appetite
• Profiting From the Copper Indecision
• Capital Flight Out of Greece
• U.S. Dollar Index Showing All Sorts of Weakness