In the Least Ugly Contest, the Dollar Is Ready to Rally!

Fundamentally, the U.S. has major problems. The government’s budget deficit is projected to hit a record $1.6 trillion this year — nearly 11 percent of the gross domestic product, making it the biggest gap between spending and revenues since World War II. And it is facing annual deficits of more than $1 trillion as far as the eye can see.

Even the Bank for International Settlement (BIS), often called the central banks’ central bank, has admitted that the current debt policy in the U.S. is unsustainable. Sooner or later it will lead to a funding crisis, which will then force major economic and political adjustments.

But Europe isn’t doing any better …

For example, credit default swap spreads on Greek government bonds recently widened by 24 basis points when Moody’s slashed the country’s credit rating three notches to B1. It has become increasingly obvious that Greece’s debt problem has not been solved and cannot be solved without debt restructuring — the politicians’ way of saying “debt default.”

Ireland and Portugal are in the same boat. And Spain isn’t far behind. Since Spanish real estate is still massively overvalued — some economists say by as much as 40 percent — Spain looks like an accident waiting to happen.

And what are Europe’s politicians doing about all of this?

Well, they are pretending that everything is A-OK and the European rescue package was the final solution to this major problem. Of course it is not …

You can’t wipe out mountains of debt by simply issuing more debt! The rescue package was nothing more than kicking the can down the road. It bought them some time. But it didn’t get them one iota closer to a solution.

And for an idea of what’s in store …

Look at Ireland for a Clue

Ireland just voted for a new government. I interpret that as a clear vote against the severe austerity program the European Union (EU) has urged Ireland to implement. Yet the Irish population has no incentive to bear that policy’s painful burden. Why should they?

After all, most Irish government bonds are held by foreign financial institutions and the European Central Bank (ECB). Why not let them share some of the burden; let them take some losses?

Didn’t Iceland do relatively well after it simply repudiated its debt? Why not follow this easier path, the Irish are understandingly starting to ask, even if the cost of doing so is to get rid of the euro.

And Greece, Portugal, Spain, and others might come to the same conclusion.

So as far as the dollar and the euro are concerned, it all comes down to a contest of ugliness … and you have to pick which is the least ugly!

But before you pick, you must understand that …

The Euro Has an Additional Problem …

The EU has a major disadvantage compared to the U.S. in dealing with over-indebtedness: Singular national interests. Therefore it is much more difficult for European politicians to go along with the unavoidable and accept the tough choices that must be made.

Agreement over necessary major spending cuts and potential defaults, which will undeniably bring hardship in the short- to- medium-term, is very hard to come by.

That’s because national interests vary widely …

For example, what’s in the best interest of Greece, Ireland, Portugal, or Spain is definitely not what Germany and the other relatively healthy countries want.

The dollar has problems, but the euro’s dilemma is a whole lot worse!

The likely outcome of this explosive mix, a euro crisis, is becoming increasingly probable. What’s more, the chances of the euro not surviving in the coming years climb with each passing day.

There is no easy way out of the European government debt trap. Sooner or later someone will opt for a severe hair cut. Then all hell will break loose with the euro.

Of course there is widespread unwillingness to accept the unavoidable in the U.S. as well. But compared to Europe, chances are much greater that a national agreement to make these hard choices will finally be accomplished.

So to me it seems that there are fewer obstacles to overcome in the U.S. than there are in the EU.

Plus there is a lot more at stake for the U.S. than just another recession, even a very severe one.

You see …

The U.S. Has a Reserve
Currency to Lose

The U.S. has a huge privilege its economic and political elite are well aware of: The dollar is the world’s reserve currency. Losing this privilege would be a major long-term loss not only for the economic well being of the nation but also in terms of global dominance.

Ben Bernanke and his predecessor, Alan Greenspan, fell short of the responsibility that comes along with this privilege. Their easy money policy played — and still plays — a prominent role in digging the hole the U.S. is in. And Bernanke doesn’t seem to get it! But this, too, will change. Or there will be a change in Fed chairmanship.

To me it’s more like a question of time until the U.S. accepts the truth and starts doing the right thing. If not, the nation will face a crisis of major proportions.

It is not clear, though, when the time for a return to sound fiscal and monetary policy will come. That’s why I am a long-term dollar bear and a long-term euro bear. This of course means that I am a long-term gold bull.

The same fundamentals that strongly impede fiat currencies support the long-term gold bull market. Therefore I suggest investors consider taking a long-term strategic gold position in a gold exchange traded fund (ETF), like GLD, until a major policy change comes about.

But that doesn’t mean there aren’t any …

Opportunities in Paper Currencies

Currently, the dollar’s decline in terms of other currencies seems somewhat overdone. And technically the dollar looks appealing. As you can see in the chart below, the Dollar Index, which measures the dollar against a basket of currencies, is sitting at a major uptrend line.

At the same time sentiment indicators towards the dollar are as bearish as they get. In fact, they’re back to levels last seen at the important lows of October 2009 and November 2010.

Look at the following chart for the positioning of what the Chicago Mercantile Exchange (CME) calls large speculators. Their cumulative position against the dollar is larger now than at the low of March 2008 and November 2009 — when the dollar was much lower.

So it’s very probable that the dollar will soon shoot to the upside — at least for a few months. If you’re inclined to get in on that action, now might be a good time to buy an ETF like PowerShares DB U.S. Dollar Bullish ETF (UUP).

And for clear, concise instructions on how to use currency ETFs and options for the biggest possible payoff, you should check out my colleague, global currency expert Bryan Rich’s latest presentation.

Best wishes,

Claus