The Daily Reckoning PRESENTS:
China and Japan have stopped buying U.S. bonds...leaving just the hedge funds to support America’s teetering towers of debt. Watch out below!

You can’t keep a bad currency down, the dollar bulls would have you believe. After reeling off an 8% rally against the euro since the beginning of 2005, and making a new seven-month high, global currency traders seem to be telling us the buck is back.

Not quite. The dollar has its pros and cons. We’ll take a look at three of each in moment. But in truth, there is less to the current dollar bull market than meets the eye.

What’s more, investors could see a surprising rally in the euro in early June. And for the remainder of 2005, look for strong performances from Asian currencies, grains, and - of course - gold.

But first, what’s so good about the dollar? There are three plausible reasons to be a dollar bull. The first and most compelling is that the dollar is not the euro. In beauty pageant terms, the dollar is a grotesquely fat currency wrapped in a skimpy bathing suit. One does not need a lot of imagination to see the flaws. But if the dollar is shapely in an obese way, there is little in the slender euro to please the investor’s eye.

This coming Sunday, May 29th, the French go to the polls to vote on the European Constitution. The Dutch follow three days later. And earlier this week, Gerhard Schroeder’s Social Democratic party lost elections in Germany’s North Rhine-Westphalia region. Political defeats for the key proponents of the European Union - Schroder and French President Jacques Chirac - are virtual defeats for the euro as a world reserve currency to rival the dollar.

What’s more, as a paper currency backed by over-spending governments, the euro is no more fundamentally sound than the dollar. In fact, there are many bad things one could say about the euro, including “non”. But if markets are even moderately efficient, much of the bad news is already “priced in” to the euro. How much higher can the dollar go by virtue of not being the euro?

“But the dollar has already crashed!” dollar bulls declare. True, the dollar has come out of its two-year pub brawl...fighting with the euro and the yen...looking considerably worse for the wear. But it’s still standing, we are told. And it still looks an awful lot like the only currency in the world capable of being a real reserve currency.

Finally, the dollar has rising interest rates on its side. Tuesday’s release of Federal Reserve meeting minutes indicate the US central bank is intent on raising interest rates at a measured pace. The prospect of rising US yields is in contrast to the lowest German interest rates since ’96...that’s 1896, according to currency strategist Chris Webber.

With a growing spread in interest rates favouring holders of the US dollar, why wouldn’t the dollar continue to rally?

But for each and every reason to “buy” the dollar, there’s an opposite and more powerful reason to “sell” it. We’ll look at them in a moment. And if the dollar doesn’t rally for the rest of this year, what should you – as a British investor – be doing to hedge your US exposure in 2005/06? First however, let’s remind ourselves what the dollar isn’t.

Just as the dollar bulls believe it has rallied because it is not the euro, so too will it fall because it is not gold. The Philadelphia Gold and Silver Index recently “violated” two multi-year up-trend lines. Gold stocks are breaking down out of their bull run, or so it would appear.

What has changed fundamentally? Nothing, of course. The dollar bulls are treating gold’s rally since 2001 as part of a run-of-the-mill cyclical rally in commodity stocks that has now run it’s course...as if 25 years of under-investment in mines, refineries, and productive capacity can be overcome by a nice rally in commodity stocks!

In the greater monetary scheme of things, of course, the dollar is still what investor Doug Casey calls “the unbacked liability of a bankrupt government.” Gold, for its part, is no one else’s promise to pay. It’s yellow, inert, and a store of value that cannot be inflated away in Brussels, London or Washington. No short-term rally in the dollar can change that.

That brings us to the second reason to doubt the dollar bulls and remain firmly in gold - America’s deficits are not getting any smaller. And there are more ominous events to consider, too.

The US Treasury’s latest report on International Capital Flows shows that since last August, the Japanese have reduced their holdings of US Treasury bonds by $19.4 billion. Not a huge decline. But importantly, they are not increasing their buying of US bonds. Across the Sea of Japan, and the Chinese have increased their holdings, but not by much, from $201.6 billion in August 04 to $223.5 billion in March 05.

The most notable increase in fact comes in London, or rather, the UK including the offshore tax havens of Jersey and the Isle of Man. These holdings of US Treasury bonds DOUBLED over the 8 months to March. Across the Atlantic, meanwhile, Caribbean Banking Centres - or what I call off-shore US hedge funds – have also increased their holdings of US Treasury bonds. The Caribbean is to Wall Street what Britain’s offshore havens are to the City of London. Since August, the US hedge funds have increased their Treasury holdings by 44%.

But unlike the UK’s steady accumulation of US Treasury debt, the Caribbean’s holdings actually fell between August and December, down to $71.4 billion. Then, since December, US hedge funds have increased their offshore Treasury holdings by a whopping 92%.

Were the City and Wall Street funds out to support America’s consumer spending habits? Not likely. In the great hunt for yield, 4% on a US bond is better than zero percent in Japan. But here’s the important fact for dollar bulls: hedge funds, unlike Japan or China, have no interest in a strong or a weak dollar. They are merely out to make money where they can.

And that’s fine. But here’s what investors cannot afford to forget: hedge funds will sell when a better trade comes along OR, when they are forced to liquidate.

The mainstays of the US bond market, China and Japan, aren’t buying. Hedge funds are. But their support for the dollar, which has the effect of keeping interest rates down, is merely a trade, not a policy. When the hedge funds sell, or quit buying, who will pick up the slack? No one.

Interest rates will go up. Puff goes the American housing market. Down goes the dollar.

All of which is to say that there is a lot less support to the dollar than meets the eye. The dollar is simply GM in waiting. US bonds are distressed debt owned increasingly by fund managers desperate to eke out a few basis points here and there. This is not the bedrock of a strong rally in a currency.

The dollar is a long-term sell. But if not the euro, what will it fall against next? Well, while the dollar rally story is shallow, the commodity bull story is still deep and rich.

A twenty-five year period of under-investment in productive capacity in commodities is not simply erased by an eighteen-month bull market in commodity stocks. The world still needs new refineries and more liquid natural gas terminals. There are still lots of global bellies to feed and cars to be fuelled. The drivers of commodity demand—large, industrializing populations in Asia competing with Westerners accustomed to high wages and high standards of living—are still going strong, even if commodity stocks are not at the moment.

When the dollar falls again – which it will - it will also fall against Asian currencies, especially in anticipation of a yuan revaluation by Bejing. It is possible, of course, that the dollar can remain stronger for longer than anyone expects. But the whole currency regime can come crashing down much more quickly than anyone expects as well.

It doesn’t happen often. But it does happen, and when it does, it happens despite the fact that most people think the world will always work the way it works today.

© 2005 Dan Denning
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Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends. His weekly e-mails and monthly newsletter give investors the most complete picture of what's shaping investment markets, what's coming next, and exactly what to do today You can sign up for a free subscription to the Daily Reckoning here: http://www.dailyreckoning.com. This essay was originally published in The Daily Reckoning.