Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Jim Rogers Predicts Dollar Rally Amid Stock Correction; Sell Dollars on Strength

Montreal, Canada

Jim Rogers, who co-founded the Quantum Fund with George Soros in 1970 and subsequently went solo several years later, is now widely regarded as one of the premier global investors. He's also been instructive to my investment career since 1991; no other investor has made a bigger mark on my investment strategies than Rogers. I'm sure many other investors have been equally inspired.

Rogers, who now lives in Singapore and is the author of several books on global investing, including my favorite, Investment Biker (Random House), thinks the U.S. dollar is poised to rally at the same time global equities post a long overdue correction. The U.S. Dollar Index is heavily oversold and has plunged 14.5% since hitting a post-August 2008 high of 89.17 last March.

As the dollar eventually rallies global markets are likely to violently dislocate – depending on the duration of its recovery.

Over the last 26 months, the dollar has proved to be one of the few beneficiaries of a global crash along with Treasury bonds, the Japanese yen and, to a lesser extent, gold.

Each time risk-based assets decline sharply, the dollar rallies. This inverse relationship to risk has caused all sorts of dislocations for leveraged traders since mid-2007 and will probably result in more losses should the dollar's rally last several months or longer. That's because the dollar is the new "whipping boy" among traders whereby the carry-trade is facilitated by cheap zero percent U.S. money and then sold and deposited, for example, in Australian dollars at more than 3%.

The Norwegian kroner, ranked among the strongest currencies this year along with the Brazilian real, is another beneficiary of the dollar carry-trade since it provides a greater yield. Both units are also surplus currencies – driven mostly higher because of booming commodity exports.

Any dollar rally, in my view, must be seen as another opportunity to sell the currency in favor of gold, the Norwegian kroner, the Canadian dollar and the Euro. If the market is beginning to discount a U.S. rate hike next year then I've got to believe a rally will be short-lived because the country can't handle an interest rate shock or a strong currency. The Fed might tighten in 2010 but much less aggressively than other central banks.

The United States cannot tolerate a strong currency in this cycle because it is still trying to defeat the forces of deflation across several segments of the economy – namely real estate, bank lending and the loss of financial intermediation. The last thing the U.S. needs is a dollar bull market. The Chinese, as the world's largest exporting nation, also can't handle a strong dollar since their currency is still largely dollar-pegged.

Over the next several months more central banks will raise short-term interest rates as the pressures of post-crisis fiscal management become a necessity. Already, the Reserve Bank of Australia has tightened and the Norwegians are likely to follow suit later today in Oslo. Though I don't expect an aggressive cycle of central bank tightening in this environment of slack industrial capacity and rising unemployment, it is clear that this phase of the "easy money" period is now almost behind us. This implies new headwinds for financial markets over the next 12 months.

Again, use any intermittent dollar rally as another opportunity to dump dollars. There's absolutely no compelling case for a dollar bull market any time soon. The nation has completely gone off the deep end, recklessly spending out of control and in the midst of a massive spending spree that's about to finance healthcare reform at the worst possible time.

The Fed has no exit plan after this cycle and, for all intents and purposes, is the cause of systemic risk in the financial system. The Fed should be abolished while the dollar, at the very least, is demoted to a multilateral global exchange rate system whereby its role as reserve currency is shared by other more fiscally responsible nations. Unfortunately, a crisis of epic proportions will force a U.S. reserve currency downgrade sometime in the future. Got gold?

Decline of the Dollar

- Dugald Malcolm

Montreal, Canada

Earlier this month while writing about gold, I posted a chart of the U.S. Dollar Index to demonstrate the abysmal state of the U.S. Dollar. The index is valued relative to a basket of currencies, including Euros (57.6%), Japanese Yen (13.6%), British Pound Sterling (11.9%), Canadian Dollars (9.1%), Swedish Kronor (4.2%), and the Swiss Francs (3.6%).

The chart I posted, similar to the one above, shows the downward trend line that has plagued the dollar since early March. I also made reference to the Death Cross of the moving averages that occurred in June. This does not bode well for the dollar, which continues to push its way lower. What's more, it still has room to move lower; I have included possible levels of support on the chart above at 74 and again just below 72, a low made back in spring of last year.

While this short term downward trend is dismaying, it becomes downright scary when we realize that this is not a new story. If we go back over six years ago, to the beginning of 2002, we see that the dollar index began its medium term downward trend as defined by the chart below.

It becomes absolutely nauseating, however, when we go back even further. The next chart goes back a quarter of a century, all the way to 1984, where we see an even longer term downward trend of lower highs that has been in place since then:

This staggering decline of the dollar has brought about a new reality for nations and their foreign reserves. According to data from Barclays Capital, countries around the world have put 63% of their new cash reserves into Euros and Yen during the second quarter of 2009. This represents the highest level it has ever been in any given quarter. The 37% of cash reserves that the dollar now comprises is the exact opposite of what it was 10 years ago, when it, not the Euro and Yen, represented 63% of total reserves.

While I have used the dollar's depreciation in my case for having gold in one's portfolio, the same case can be made for foreign currencies as well. Astute individual investors should follow the example of the central banks and make currency diversification a part of their portfolio - including, of course, gold. In fact, we have doubled our gold exposure for our managed accounts since last week on possible further dollar weakness.

Have a good weekend!

The Next Currency Crisis?

Montreal, Canada

Is the EUR a suitable alternative to a falling dollar? Are other currencies any better?

Over the last decade a record number of central banks worldwide have reduced their exposure to U.S. dollars while raising their allocations to the EUR and to a lesser extent, the Japanese yen. According to a recent report from the IMF, central banks today hold about 63% of their total reserves in dollars – a record low.

 

Since it was introduced in 1999, the EUR has gained a cumulative 28% versus the American dollar; the buck has also declined against every other major and peripheral currency in the world. Only once this decade has the dollar rallied – in 2005.

Current trends among central banks might be feeding a dollar bear market or likewise fueling a gold bull market.

Central banks are notoriously infamous for buying and selling currencies at the wrong time. This is also true regarding gold when dozens of banks continuously dumped the metal in the latter half of the 1990s – just as prices formed a bottom. In fact, central banks are among the worst market-timers – and not just the major central banks.

Banks in the oil-wealthy Gulf began aggressively buying dollars in 1999, 2000 and into 2001 just as the buck was completing a multi-year bull market that began in 1995.

Probably the shrewdest central bank is the People's Bank of China, who recently admitted in late April to holding twice as much physical gold in its coffers than officially reported to the World Gold Council. China, Russia and several other emerging market central banks are buying gold while advanced economy central banks have sold most of their stash – except Germany and the United States.

Are the emerging market central banks wrong to accumulate gold? I doubt it. But they might be wrong buying the EUR and yen – an admission they might be forced to make in the absence of a suitable dollar alternative with abundant liquidity.

Why is the EUR such an ideal alternative to the dollar? Despite being the second most liquid tradable unit in the world does it really deserve to be at current levels? The answer to that question is a resounding "No."

In August, the euro-zone's trade balance swung to a deficit from a surplus in July after exports plunged to their lowest levels in 4 ½ years. Budget deficits are already heading through the roof across the region – even in Germany.

The original guidelines of the Maastricht Treaty, which strictly defines budget deficit limits to 3% of GDP has been breached by most members in 2009. Though not a profligate as America, the Europeans are printing mounds of cash to desperately grow money-supply and inflation. Thus far these policy initiatives have failed.

If the EUR is such a great alternative then why is it plunging vis-à-vis the Brazilian real (-20%), the Australian dollar (-16%), Norwegian krone (-13%) and 8.5% against the Canadian dollar? Is this simply because commodities have surged since March? And against gold the EUR is dropping again, down 13.6% this year.

The EUR is not a great alternative to the dollar. The fundamentals for the single currency are poor and the prospects for devaluation are growing by the day; the lower the dollar falls, the higher the risk one or two single currency participants will leave the EUR or break from the currency grid. These include the Italians, the Greeks, and possibly the Portuguese.

The EUR is a mish-mash currency plagued by poor domestic consumption, rigid labor laws, high production costs across the region and a banking system that still starves capital. It's also wrestling with a massive leveraged buyout of Eastern Europe this decade, which is still unraveling. Yet it seems the foreign exchange market has not assigned a risk rating to this outlook; EUR investors are delusional.

Jim Rogers, one of my mentors over the years and probably the smartest global investor along with George Soros and Julian Robertson since the late 1960s, once told me the major currencies (USD, EUR, Yen) are like a "bunch of drunks at a bar, all intoxicated by rising debt and competitive devaluations; they're all no good." He was spot on. That phrase stuck with me since he first uttered those words in an interview back in mid-1995.

The EUR might be better than the dollar – almost anything is. But what does this really say about the EUR and other currencies? It says the global exchange rate mechanism is badly fractured, largely dysfunctional and prone to high inflation over time as paper money buys less and less as per our wages. It's truly a sad story.

All currencies are now in a downtrend versus gold since 2005.

Gold, and to a lesser extent, silver and oil, are ideal hedges against all currencies. The EUR is not a haven and is vulnerable to a crisis over the next several years. It's unlikely the single currency will survive without a severe devaluation – especially if the dollar remains weak, punching a hole into her exports at the very moment the region is desperate for economic growth.

Paper Money Losing Credibility

Montreal, Canada

Earlier this year I reduced my gold exchange-traded-fund holdings by 50% around $950 an ounce as I anticipated another deep correction for risky assets. Though a decline followed, gold prices recovered quickly and I admitted to making a mistake. I regret not keeping that position.

However, I did buy gold stocks last summer – a Canadian dollar denominated ETF – and I'm quite pleased with its performance over the last few months. But owning gold stocks is not the same thing as owning gold. Often, investors confuse these assets forgetting that historically deviations have occurred when gold prices have rallied while gold stocks have simultaneously declined and vice versa; I believe investors should overweight bullion and underweight the mining stocks.

My take on a correction back in May was that stocks were in the midst of another bear market rally and would succumb to profit-taking once more; a stock market sell-off would take commodities, including gold, sharply lower and the dollar higher. That never happened.

I plan on doubling my gold holdings today for managed accounts and funds in Europe and the United States. I don't think we'll see $1,000 or triple-digit gold prices for the next several years – if ever again. Even if we do, prices won't stay at those levels for long. Any correction in gold prices should be viewed as an opportunity to buy more of the metal – something I failed to do last spring. I won't make the same mistake twice.

As an investor or money-manager you must be prepared to accept risk. Otherwise, there's no reward and in the absence of some volatility your returns over time will be dull and uninspiring financially.

If you assume risk, then you'll make mistakes. No investor in the history of the world has ever called every trade – we all make mistakes. The way to succeed is to limit your losses (stop-losses) and keep the biggest speculations small as a percentage of your total portfolio.

Gold, however, which is inherently volatile, is now the only real money in the world capable of protecting our purchasing power. It deserves a core allocation in your portfolio.

The Federal Reserve as bastion of the world's reserve currency is on a course to print money like never before following its "quantitative easing" program last year – basically a fancy term that means "print or die." The Fed is out of control and really has no exit strategy to reign in all this massive credit creation; interest rates will stay low for a long time or until employment accelerates again.

The odds highly favour a major spike in inflation over the next few years – probably the worst inflation since the 1970s. Governments need inflation, a monetary phenomenon that remains in short supply since mid-2008 as real estate, bank lending, credit growth, wages, financial assets and oil all remain well off their highs.

The dollar and other currencies for that matter will continue to decline vis-à-vis gold for the foreseeable future because nobody wants a strong currency. Almost every central bank is printing money and since all markets are highly correlated in the age of violent capital markets, there's isn't a single currency that stands to protect your wealth – not the dollar, not the EUR, not the CAD or the yen. Not one. They're all no good.

So here I go again. I'm buying more gold today. I just can't see a better alternative as paper money continues to purchase less and less against gold since 2005.

The 1930s, Rising Taxes and Gold’s Confiscation

Montreal, Canada

Did a surge in individual and business taxation in the 1930s exacerbate the Great Depression? If so, the trend in state and federal government taxes isn't friendly to an economy that remains badly fractured by weak credit demand and rising unemployment.

In yesterday's Wall Street Journal (page A25), Arthur Laffer (Laffer Associates) makes a strong historical case about taxes, the Great Depression and comparisons with today's economic challenges. His findings make for a sobering read.

If he's right, we're heading down the wrong path over the next two years as tax rates rise significantly following the expiration of the Bush tax cuts in 2011. And raising taxes in the middle of a recovery is not the way to build prosperity. The late President Reagan knew that but Obama lives on a different planet.

According to Laffer, "The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s."

Laffer also goes on about gold and how government confiscation of the yellow metal in May 1933 blew deflation fears wide open as the public flocked to gold; the metal was fixed to the dollar at $20.67 an ounce. Fears of a dollar devaluation vis-à-vis gold unleashed a gold-buying panic by mid-1932. U.S. consumer prices plunged a cumulative 27% from late 1929 until early 1933.

By early 1933, the federal government under FDR declared a bank holiday prohibiting U.S. banks from exchanging dollars for gold; the public was not permitted to exchange foreign currency, either. If you held gold, most of it was to be handed back to the government at the official rate of $20.67 an ounce; by January 1934, however, the government revalued gold at $35 an ounce.

Says Laffer, "In less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That's one helluva tax."

Meanwhile, dollars were apparently in short supply last year as the credit crisis blew wide open. Or were they?

The same fears didn't play-out last year as the financial system almost collapsed.

From July 2008 and until March 2009 the dollar went through the roof in what is widely believed to be a "flight to safety" amid outright panic. But I don't buy that. The dollar rallied because de-leveraging was in full force coupled by massive redemption requests from global investors as they dashed out of risky assets and headed almost overnight into cash.

How can the dollar be a "safe haven" when the epicentre of the financial crisis lies in the United States? I can't make sense of that anomaly. I mean, c'mon, the Fed is printing like a drunk and the government has committed something like $12 trillion dollars to this mess. Then we've got Social Security, Medicare and other unfunded entitlement programs – you know the rest. How on Earth can a sensible investor scramble to buy dollars?

I also don't buy the euro or other currencies as a "safe haven" because they're also plagued by similar problems – some worse than others. There isn't a single currency out there that's better than gold. Not one.

Basically, gold is the only asset outside of the credit system that remains no one else's liability. And that's why it's rallying in 2009 – its ninth consecutive calendar year gain.

What is your Base Currency?

Montreal, Canada

Risk level and currency factors are perhaps the two most important variables for an investor to determine prior to commencing a global investment portfolio. Sadly, most investors fail to determine their appropriate risk level and worse, fail at understanding what the wrong currency exposure can imply to long-term portfolio returns.

Over the course of seventeen years managing private and institutional assets, I’m convinced the worst mistake investors make is failing to understand the meaning of “currency risk.”

It’s amazing but many investors spend more time determining what currency exposure they want rather than focusing on what might happen if that currency gamble turns the wrong way. After all, currencies and commodities rank as the most volatile assets and investors can win big or lose their shirt quickly in these fast-pace markets.

Basically, if you earn and live mostly in U.S. dollars, for example, then speculating with most of your assets in foreign currencies might result in serious losses of your purchasing power. Of course, in retrospect this speculation would have been brilliant this decade because the dollar has tanked since late 2001. But timing is everything in life and if you bought foreign currencies in 1995 and needed those same funds in dollars five years later you would have lost more than 50% of your purchasing power when converted back into dollars.

From 1995 to 2001 the dollar posted big gains against most foreign currencies as the Clinton-Rubin years produced budget surpluses and a bull market in almost everything American, including technology stocks.

Since nobody can predict the future it makes sound investment sense to always maintain a diversified portfolio. This means holding a range of foreign currencies for the long-term and most especially, gold bullion. You should also hold growth-based investments like equities, hedge funds, managed futures and bonds. But if you’re about to launch a global growth portfolio then choosing a sensible investment program in your base currency is the first hurdle you’ll have to determine.

Here’s what I tell my prospective investors: If a dollar-based client approaches me and he’s truly worried about the long-term decline of the dollar (and who isn’t?) then I suggest having him purchase 10% in physical gold (coins, wafers) for currency insurance and perhaps another 10% into non-dollar foreign currencies – outside of the assets I’ll be managing for him. This way, he’s invested in a long-term non-dollar plan that won’t require me to trade his portfolio of securities if the dollar starts declining.

Now don’t get me wrong. The portfolios I manage today hold some gold, commodities and foreign currencies. And in the future they’ll probably hold much more of these hard assets. But we’re mostly in dollar-denominated investment products and I don’t want to start trading these securities every time the dollar declines or buy them back when it rallies. That’s not how I manage money. Trading means fees and fees are the cancer that erode your portfolios’ value.

A dollar or a EUR-based portfolio should achieve three important objectives: First, it should outpace inflation (CPI). Second, it should outpace the risk-free rate on cash, which is 3-month LIBOR plus 3% in my book or 3.50% right now for dollar accounts. And third, it should outpace the MSCI World Index over a five-year period.

You can also add a fourth variable such as outpacing the U.S. Dollar Index or a basket of major non-EUR currencies over a five-year period. What I’m striving to achieve is to protect my investors’ purchasing power in their base currency. I can’t possibly beat the EUR every year if I’m dollar-based or outpace oil, gold, stocks, etc. What I want to do is make sure the client doesn’t lose money in his base currency.

In my experience, it’s far more important to own the right asset allocation and mixture of securities than picking the highs and lows of the currency market. It’s almost impossible. If you’re considering a global growth portfolio then make sure your advisor is properly diversified across asset classes and currencies. But don’t breathe down his back every time the dollar declines because, at the end of the day, currency speculation will usually result in big losses – especially if your base or home currency is compromised.

Curious about China’s Dollar Sabre-Rattling

Montreal, Canada

In the absence of a major stock market decline or another financial institution blow-up this summer it’s probably a safe bet to start nibbling at foreign currencies again.

The U.S. Dollar Index (see enclosed chart) broke important support levels last month but is now oversold on a short-term basis. Any dollar rally at this stage of the economic cycle should be tepid at best. The economy is stuck in a de-leveraging process that will take a few years to unwind coupled by scant bank lending in an environment of cash hoarding. This is not a macro environment that will boost U.S. short-term interest rates any time soon.

The United States and probably China, to some extent, desire a weak American dollar to boost domestic inflation. U.S. CPI is still contracting and in May declined for the third straight month to its lowest level since 1955. A lower dollar helps to grow inflation – a desperate commodity right now.

This morning, China launched another currency salvo claiming the world should look “for alternatives to the U.S. dollar.” Such utterances won’t boost the buck but instead likely help facilitate a decline. Interesting how China would slam the dollar when she holds about 35% of all Treasury bonds in circulation.

On Tuesday, I began buying small positions for my managed accounts in Canadian dollars and Norwegian kroner. Gold remains 5% of my portfolio for now.

Though I remain cautious about commodities this summer, including oil and gold, I like the CAD and NOK currencies because of their relatively stronger balance sheets; Norway, in particular, smarts a 10.5% budget surplus-to-GDP ratio – the highest among industrialized nations. This compares to rapidly rising or skyrocketing budget deficits across the major economies since late 2007. And Canada, though now in budget deficit, sports a small deficit compared to its overall economy.

What about the euro? The single European currency is probably better than the dollar but not by much. I prefer gold, NOK and CAD.

Several peripheral euro-zone economies are now in deflation and major trading partners to the East are in desperate need of bank capital. I’m still predicting some sort of blow-up in the Baltic Republics or the Balkans this year. Any macroeconomic collapse in these regions will hit the euro and the emerging markets new “bubble” hard.

The precious metals should rally if the dollar continues to weaken. But, like I said earlier, I’m just “nibbling” at foreign currencies here to build fresh positions that are part of a long-term accumulation strategy for my dollar-based accounts. Any sell-off in risk-based assets this summer – highly likely ahead of earnings guidance and a 40% post-March rally – will drive the dollar higher. That’s when I’ll add to my existing foreign currency holdings.

Gold and silver, however, remains hostage to traditional summer weakness in the commodities complex; gold is especially vulnerable near-term because jewelry demand has collapsed and any outflows from gold-related ETFs will drive the price sharply lower. I’m looking to re-enter gold around $875 to $850 and silver around $14.

It strikes me as fascinating that China is denouncing the dollar again. Something is cooking in Beijing and Washington whereby policymakers probably welcome a weaker dollar.

This should be another very exciting summer marked by renewed volatility, especially in the currency markets, which have been largely range-bound for the last four weeks.

Have a good weekend. See you on Monday.

Sell Dollars on Next Rally…

Oslo, Norway

This is my second visit to Norway since May. Oslo is a great city and a superb walking town. Just 100 meters from my hotel is the Norwegian Parliament building and from there a great “Handler Ømradet” or shopping area littered with all sorts of interesting things to see and buy.

I’ve always been fascinated by Scandinavia and its rich history. I first visited the Nordic region in 1996 when I established a private banking relationship for my investors in Copenhagen. Today, that relationship has grown as Jyske Bank Private Banking represents about 20% of my total assets under management.

I’m in Norway this week to explore asset management potential. This is a country where investors get into bed with foreigners very slowly, especially after the Bernie Madoff fraud and other international fiascos. Norwegians take their time before making an investment – something many of us can learn from to avoid painful and costly mistakes later.

Norway's currency now ranks as one of this year's best-performing major currencies in Europe and isn’t far behind the Brazilian real for the world’s top currency title. In 2009, the Norwegian kroner is up about 10% and has appreciated 8% against the EUR. The British pound has surged 12% in 2009 but only after crashing in 2008; the pound remains a bad bet over the next several years amid a flood of debt issuance to finance its almost insolvent banking sector.

In a world laced with debt-infested currencies the kroner probably has the best balance sheet. Norway is sitting on bulging trade surpluses – mainly because of oil and gas exports – and is home to the world’s largest national pension scheme valued at roughly $350 billion dollars. If you’re looking for a model currency then Norway fits the bill. The country has a positive trade balance and a budget surplus. This is why the currency is strong.

The U.S. dollar, of course, has been heading to the relics of history since Nixon closed the gold window almost 38 years ago this summer. With the exception of a few big counter-trend rallies in the 1980s and 1990s, the dollar has been progressively hitting newer lows every decade. No wonder; out of control spending, two military conflicts and a seemingly never-ending budget deficit don’t bode well for the American dollar. Yet despite all of this overwhelming data the dollar might just be at the cusp of another big bear market rally.

Longer term, no rational investor can make a compelling for the dollar. Yet it seems plausible that if the United States was the first to enter a hard recession in December 2007 that it might also emerge out of recession before any other country, except China and India. The dollar has been pounded over the last few weeks and is oversold. I’m also not so sure why the EUR and other currencies are rallying because they’re just as bad. Yes, the dollar is a total drunk but so are her other trading partners; it’s just a question of how much each currency has consumed at the bar. Since last year it’s been Happy Hour – everyone is piling on debt.

The dollar is therefore likely to post a major counter-trend rally this summer or fall – fooling a lot of investors. This is especially true if the stock market and other risky investments begin to falter again; the dollar would recover rather quickly as short positions are rapidly closed.

As profit-taking eventually sets in this summer I suggest unloading dollars for Norwegian kroner and Canadian dollars. I don’t especially like the EUR or the Swiss franc. I also think most Brazilian assets, including the real, are overbought. The Aussie and kiwi are okay but Norway and Canada offer stronger balance sheets. I’m also a long-term oil bull – something Australia does not produce, unlike Norway and Canada (oil sands and natural gas).

Don’t dump dollars now. At some point later this year or even this summer investors will have another chance to sell dollars for NOK and CAD. Also, don’t forget about gold, which is also likely to crack and possibly test $900 or $850 before finally breaking the $1,000 an ounce level for good. Gold is by far the best monetary value (no one else’s liability) in a world filled with currency drunks, bulging deficits and ultimately, serious inflationary consequences once central banks kill deflation.

Loonie Best of the Drunken Bunch as Canada’s Balance Sheet Stands Above the G-7

As risk returns to global markets since March, the Canadian dollar along with a host of other foreign currencies, including commodity currencies, has surged versus the American dollar. In May, the Canadian dollar logged its strongest month versus the U.S. dollar in more than a decade gaining 8.5%.

Over the same period, the loonie has also proved to be highly correlated to crude oil; commodities posted their best month in May since July 1974 with oil prices surging 30%.

To be sure, the Canadian dollar is overbought at these levels and will probably correct lower along with commodities at some stage this summer as profit-taking finally emerges following big gains in stocks, speculative and investment-grade debt and commodities since March 9.

But Canada does have its share of problems in 2009.

Red ink has started to emerge following years of budget surpluses while in some provinces, namely Ontario, have amassed big deficits amid a manufacturing recession and General Motors’ recent bailout. Ontario’s budget deficit has already surged 31% this year compared to 12 months earlier.

Canada is now poised to record its first budget deficit in more than twelve years.

According to the Department of Finance the estimated deficit for 2008-2009 stands at C$2.25 billion dollars or double January’s projected C$1.1 billion dollar shortfall.

The global credit crisis has hit Canada’s manufacturing belt in Ontario and Quebec particularly hard with unemployment rates above the 8% national average through April.

Government revenues are also on the slide.

Tax receipts in March dove 20.8% in Canada led by a stunning 46.8% plunge in corporate tax revenue. In the first quarter Canada’s gross domestic product, or GDP, contracted 5.4%.

Canadian trade is also taking it on the chin this year. The country’s current-account deficit for the first three months of 2009 was a negative C$9.1 billion dollars, up from a revised C$7.8 billion dollars in the fourth quarter. The first quarter trade deficit was the largest since Statistics Canada first began compiling records back in 1946.

The federal government now projects a C$50 billion dollar deficit in 2009. Though that’s certainly nothing to sneeze at it certainly pales to the gargantuan C$1.9 trillion dollars estimated by the U.S. Congressional Budget Office for fiscal 2009. Other countries, mainly in the G-7, are also on course to record huge deficits as a result of monster-sized fiscal spending; the United Kingdom, in particular, will probably borrow more than the entire size of the British economy over the next 12 months.

And yet despite all the challenges facing Canada amid the worst destruction in credit since the 1930s, the country is the best of the G-7 bunch.

In both absolute and relative terms, Canada looks much better than other major economies with a manageable debt level and a strong inventory of raw materials should the global economy recover.

Versus the U.S. dollar, the loonie is a far better store of value as the former amasses record budget deficits for the next several years to pay for seemingly never-ending bailouts and, eventually, a second round of stimulus spending.

Over the next several months or sooner, the loonie is also likely to fetch more than the U.S. dollar or break par value once again.

For American investors, gold, the Canadian dollar and the Norwegian kroner are among the best currency plays for the next three years and beyond.

The United States will have to keep interest low in the absence of organic domestic consumption, a long-term housing bust and the implications of the governments’ socioeconomic bailout of roughly 35% of U.S. GDP since 2008 – mainly in banking. Credit will be slow to return to pre-2007 levels while demand for debt accumulation remains virtually non-existent as consumers grow frugal for the first time since the 1970s.

Canadians, however, should accumulate gold with the loonie at these high levels. Gold prices have been declining versus the Canadian dollar since March but that trend is only temporary; since 2005 gold prices have appreciated versus all currencies, including the loonie. Apart from gold, only the Norwegian kroner offers a better balance sheet than Canada with tremendous oil surpluses and the world’s largest national state pension fund.

Canada has been fortunate. The country has not suffered a bank bailout, maintains a relatively strong balance sheet compared to its biggest trading partner and has mountains of commodity wealth to feed the world as inflation finally rears its ugly head once central banks finally defeat deflation and the ongoing destruction of credit.

Commodity Currencies Overbought Since March

Some of the biggest trend reversals in global markets since March have occurred in foreign exchange markets. As risk reversion has returned with a vengeance over the last several weeks many commodity currencies have lit a fire against the American dollar.

But the biggest movers against the dollar and the euro since March are also the same currencies that should be avoided following huge gains. These include the Brazilian real, Norwegian krone, Swedish krona, Canadian dollar, Australian dollar, New Zealand dollar and the South African rand.

With global capital markets now drunk with big gains since the lows on March 9, investors would be wise to avoid dumping the U.S. dollar at these levels ahead of another sell-off later this spring or summer. Stocks have now entered a period of seasonal weakness starting in May and significant profit-taking will probably drive the dollar and Treasury bond prices higher over the short-term.

One of the worst-performing commodity units since last July belonged to the Australian dollar (shown below).



The Aussie was smashed to bits starting last summer along with other commodity currencies and hit a trough in late 2008. At just shy of par value vis-à-vis the U.S. dollar in mid-2008, the Aussie tanked more than 40% late last year before recovering about half that loss since March.

The Australian dollar is now up 7.4% against the U.S. dollar in 2009. Other currencies like the Norwegian krone have surged 8.8% while the Brazilian real is up 10.8%. The top performer in the commodity league this year remains the South African rand, up 11.6%.

The major premise behind the impressive rally for many foreign currencies since March is the return of risk aversion or leverage. The cost of funds in the United States is almost zero percent; the dollar is rapidly becoming the next Japanese yen carry-trade whipping boy.

Though I can’t quantify exactly how much borrowing has returned to the financial system, it’s obvious to me at this point that investors are embracing too much risk at this stage of the economic cycle. The Dow, S&P 500 Index and other averages violated important support levels on March 8. This is not a new bull market.

Investors are incorrectly assuming that domestic demand, consumption and household balance sheets are now in the process of recovering, which is dangerously not the case. What we have now is massive global monetary stimulus finally feeding its way into the real economy as statistics go from outright disaster to just plain old bad. This justifies the 37% advance by the S&P 500 Index since its March 9 low; but it won’t justify broader gains from these levels because corporate earnings will continue to struggle in the absence of organic consumer-driven demand.

Yet I suspect all of this government spending, now in the process of being discounted by the stock market and Treasury bonds, will eventually exhaust itself because Treasury bonds and mortgage rates are now rising sharply since mid-April coupled with sharply higher oil prices. The market will begin to discount this soon.

The U.S. and European financial systems remain heavily leveraged and many segments of credit still rely on government support. This remains a highly uncertain economic environment and I think investors would be wise to avoid the hype and protect their capital for the most part. It’s just incredibly hard to believe that we’re back to the good old days again when deflation is now officially in town for the first time since 1955 and most companies don’t have pricing power.

If the global unwinding of leverage is indeed unfinished then the American dollar is not through completing the last phase of this bear market rally that began in July 2008.