How can we stand tall when currencies fall down?

If you looked in any outlet of the mass media recently, you’ve probably noticed at least a couple blurbs about how the recession isn’t as bad as it once was and we’re now on the verge of recovery. But we at Agora say “Hogwash!” to that. In fact, we’re willing to bet the worst is still yet to come.

Some people might look at rising prices in stocks, oil prices, etc. as evidence of a recovering economy. But that doesn’t take into account factors like new jobs or — something less tangible — the actual value of a stock. To take it a step further, one ought to look at the value of the American dollar and see how it’s declined tremendously in recent years.

Then, after looking at the dollar, one could see how it’s not the only currency in trouble. Many others around the world are now considered less valuable…and that should tell you the recession is definitely far from over.

Nevertheless, just because domestic and foreign currencies are falling apart doesn’t mean your portfolio has to, also. In fact, you could stand tall while other investors are slouched over in pain. Just read on to see what I mean…

How to Profit from the Coming Currency Crisis

Leaders the world over are sowing the seeds of the next big financial crisis. When it comes, the few that were ready are going to have the opportunity of a lifetime to make a fortune. Here’s what you need to know to make sure you’re one step ahead…

Rising living standards in emerging markets is a powerful investment trend. There are many reasons to expect this trend to continue. But central bankers and politicians all around the world, who think of ways to “improve” every possible situation with their enlightened meddling, are acting in a way that promotes future crises.

The most powerful, influential meddling right now is happening in the currency markets. By flooding the system with liquidity, and promises of much more liquidity, central banks have fueled the 2009 rally in “risk” assets.

The Federal Reserves zero interest rate policy has been the most important factor in financial markets for months. This policy is acting as an acceleration for money supply growth in many emerging economies. As Jim Grant says, the U.S. is the world’s reserve currency, so the Federal Reserve is the world’s central bank.

The U.S. dollar carry trade is prompting “hot money” to flow into countries like Australia — those with upward-trending currencies and short-term rates above zero. The Fed’s outlook for inflation focuses myopically on outdated, industrial-era statistics like the “output gap,” while its loose monetary policy fuels dangerous, unproductive bubbles.

The promises of limitless free money from central banks also embolden the big spenders in government, who are ramping up the GDP figures (but destroying real capital) at unprecedented rates. Without the belief that “quantitative easing” is available to finance deficits, big spenders in government might think twice about having to pay higher interest rates to borrow from the bond market.

The policies of central banks are also aggravating dangerous imbalances in the global economy. Countries that traditionally rely on exports are upset. With President Obama having embarked on his first official visit to China late last year, the issue of the dollar/renminbi peg is at the forefront of concern.

As the U.S. dollar index weakens, so does the exchange rate of the Chinese renminbi versus floating currencies like the Euro and the Japanese yen? This translates into an effective price cut for American and Chinese exporters, without the typical hit to profit margins. European and Japanese exporters are suffering from what they consider to be an unfair playing field.

Debasing the value of a currency is an old-fashioned way for politicians and central banks to subsidize politically powerful exporters. Cheap currency policies are widely popular among the bureaucrats and central planners that populate the halls of academia and policymaking. But over long periods of time, the quality, efficiency, and productivity of an export sector will determine its success — not whether it’s located in a nation with a weak currency.

Like doping in sports, a weak currency gives exporters a price advantage against its competitors. But once too many countries get involved in this “mercantile” type of policy, it transforms into an ugly race to the bottom. In the end, the average citizen is impoverished by diluted purchasing power.

Policies that actively weaken currencies are not good for the health of the middle class. Our “bail out bank shareholders and bondholders at any cost” policy is a hidden long-term threat to the health of the U.S. middle class. And the stimulus spending and inflation created by the Chinese Communist Party is a threat to the emerging Chinese middle class. This wasteful spending doesn’t appear to have a cost right now, but those costs will become obvious in time.

An August 2009 report from asset manager Pivot Capital Management has gained notoriety in the press lately. The report, China’s Investment Boom: the Great Leap into the Unknown, captures the bear case for China.

Some of the themes outlined in his report will relate to Strategic Short Report’s future short ideas. In preview, Chinese central planners are blowing massive bubbles in asset-heavy industries like steel and cement. The ultimate returns on capital invested in these sectors will be nonexistent or negative.

It remains to be seen whether positive global trends like advances in technology and education and the post-Soviet era trend toward freer markets and stronger property rights will overcome negative trends like the “white elephant” projects that will inevitably result from stimulus spending.

There certainly will be winners and losers in China’s capital spending bubble, and we’ll be targeting the losers… In fact, one of the “losers,” as we’ve known it to be recent years could turn out to be the next big winner in the year ahead…

Why Today’s the Time to Bet on the Dollar

We’re going to leave the foreign markets for a few minutes and look domestically to find this so-called “loser.” I’m not normally much for big predictions, but this one is a no-brainier: The U.S. dollar is going to skyrocket sometime in 2010, which is huge news for your portfolio…

I know that prediction seems to go against everything you’ve read in the Sleuth in the past. But I assure you it makes perfect sense…

Before investors lose faith in the dollar, they’ll lose faith in everything else, including the Chinese bubble and even the Chinese renminbi itself. Think of the value of the dollar as one kid on a seesaw and investments (stocks, funds and bonds) as the other kid.

When the stock market and bonds both rise, the dollar falls. That is what 2009 was all about.

But as investors rip their investments out of stocks and bonds, they’re essentially buying the dollar — jacking up the value.

The Second Peak Is Already Here

Our economy is about to relapse from the disease that sent us into the Great Depression: Part deus.

In the first half of the past decade, sub prime loans were king. They were cheap and easy to get approved. Along with the sub prime boom came sub prime adjustable-rate mortgages (Arms), which were equally easy to afford…for a while.

Of course, the “A” and the “R” in ARM meant that the interest rate borrowers pay changes, or resets. The majority of these resets occurred between the summer of 2007 and the summer of 2008.

This period saw a massive amount of mortgage interest rate hikes, which caused millions of foreclosures. Things spiraled down from there, eventually freezing nearly all credit and causing the panic of 2008.

Of course, that’s the 50-cent version of recent history. There were plenty of other financial calamities that went along with this, including the bundling of mortgage-backed securities and risky derivative products.

If you believe the Obama White House and the glass-half-full press corps, you think this mess is now behind us. We are, after all, in a recovery…right?

Unfortunately, no one is talking about the second wave of ARM resets and foreclosures…

You see, this second wave will come crashing even harder than the first. It’s made up of a type of mortgage called option Arms. These give borrowers the option of how much they want to pay during the first five or 10 years of repayment:

1. The full amortized rate, including interest and principal.
2. Full interest only, or…
3. A teaser rate, well below the amount needed to cover the interest on the loan.

This third option puts borrowers into even more debt than when they signed for the house. This can lead to mortgages amortizing up to 125% of their original balance.

After the rates reset, they can jump upward of 6% or 7%. That’s hundreds, and even thousands, of dollars in expenses unaware homeowners could incur in a month’s time.

Obviously, these option Arms were supposed to be reserved for customers with better credit than those who took out sub prime mortgages. But apparently, they were handed out to anyone who wanted them.

According to Whitney Tilson and Glenn Tongue of T2 Partners, the experts on this subject, about 80% of option Arms are negatively amortizing. Meaning these so-called top-tier borrowers are heading further into the hole. Once their rates reset, they could be in serious trouble.

And that could be happening very soon:

The chart above shows the two peaks in this long-term housing conundrum. The first mountain is comprised of sub prime ARM resets. And the second is mostly constructed of option ARM resets. We appear to be in the eye of the storm.

That alone shook our nerves when we first discovered it. But it was a different chart in Tilson and Tongue’s most recent presentation that really got us startled…It’s also the reason I’m predicting the dollar spike in 2010.

Instead of resetting as expected after the first five years, many option Arms are so negatively amortized that they are hitting their automatic reset cap.

That means they are resetting early…like right now.

As you can see from the second chart, the expected reset peak was to occur in 2011. But the real peak is happening now. You can also see that the amount of mortgages resetting is spread over a longer period of time than originally thought, but is peaking much earlier. Unfortunately, it’s not the peaks that matter.

You see, those are just resets. But with unemployment reaching quarter-century highs every month, and the massive number of homeowners about to receive mortgage bills for two–three times what they are used to paying, we find ourselves in an even scarier environment than this time last year.

It takes anywhere between 3–12 months for most homes to actually go into foreclosure. It’s tough to say exactly when the storm will come. But my guess is the second half of this year.

None of this is meant to frighten you into moving. But it does give us a little look at what to expect.

When this next domino tips too far, we’ll have quite a mess on our hands.

As Assets Fall, Everyone Buys the Dollar

Stocks will collapse — possibly even further than the last time. High-yielding bonds — which are up about 56% from last year — will also lose the faith of their speculative investors. Even gold — which is at its all-time high — will fall temporarily.

When investors sell all these assets, they essentially buy cash. Or at least that’s where they will be storing their wealth. And while it is still the world’s reserve currency, the U.S. dollar should take off.

That’s exactly what happened last time.

As you can see in the above chart, the dollar index — which compares the U.S. dollar to a basket of other currencies — took off in September and October 2008…right when markets worldwide tanked.

Who knows what this time will bring?

Of course, this boom in the dollar and fall in equities may not be the best news for our portfolios in the short term, but in the long term this is a great opportunity for investors who choose to prepare their financial for 2010.

Naturally, my colleague Jim Nelson — who has done extensive research on this topic — has already filled his Lifetime Income Report readers in on the best course of action but there are plenty of ways to play this one…and, as we talked earlier, plenty of ways to play the foreign currency markets.