Well, right now there are two major trends/debates on. First is whether the USD will continue to show strength in spite of about $3 trillion of US Treasury borrowing this year? That question applies to gold of course, and oil, and other commodities.

The second question is whether an economic recovery in the US and China will appear this year. If the US sees any sign of economic stabilization, the USD gets a lot more time to adjust without a rapid devaluation period. If the US sees economic recovery failing, the USD feels more pressure. The same situation goes for China, can their economy digest the 20 to 30% decline in exports, and have internal economic demand take up the slack (if not the world's slack).

If economic recovery appears in the US we can have another several years with a stronger USD than we might think. It is particularly interesting to see China and Russia making statements that the world needs an alternative to the USD, even going to the point of concrete action like China trading currencies with their major trade partners (currency swaps) to create alternatives to the USD for world trade. But at the same time, this week both China and Russia back track saying there is no real replacement for the USD right now.

I particularly noticed, amidst all the market choppiness, that any statements by either Russia or China about the USD are immediately reflected in the USD and gold price. Other markets are not reacting so quickly to economic news like that, rather having to digest many other pieces of data before settling to their price ranges that week. What China says in particular is instantly reflected in the USD.

In short, the market appears to be giving dialog on the fate of the USD by either China, Russia, or whoever a heavy weight. The USD state of health is still the prime topic out there. The reason is because everyone is wondering if the bond markets can digest $3 trillion of new US borrowing this year without spiking US interest rates. So far, rates have been rising.

The other major topic is whether the US and China are going to see real economic growth/improvement to make up for the implosion of the consumer bubble. Now, personally, I do not think any significant recovery will appear in either the US or China to make up for the lost US/Western consumer.

China's domestic consumption

We do see, however signs of growth in China's domestic consumption. For one thing, the Chinese are rapidly becoming the biggest auto market in the world, even overtaking the US just about now.

GM, with all its fiscal disasters in the US, is poised to grow tremendously with plants in China. In fact, the Chinese have gone on an auto buying spree this year. And they like the bigger American car designs, which is a bit of a surprise. That is a very encouraging sign that China might ramp up their domestic consumption, the only real hope for them to improve their trade balance and keep their economic momentum going. The US and West certainly have little prospect of improving for a year anyway. China's domestic demand will not be enough to replace a contracting Western consumer, but domestic demand in China is one bright spot.

So, a scenario appears where China may be on its way to navigating (or beginning) to navigate to a new phase in their own dynamic growth - a domestic consumer boom. The Chinese people have a lot of savings. But at the same time, the prospects for a US/Western consumer recovery are bleak over the next year.

So, the next question is, how will the USD fare if the US does not have a consumer recovery, and China manages to get one going? Well, one thing is for sure, Chinese domestic demand cannot come close to replacing the Western consumer at this time. But that can change.

So, the US/West is likely to continue deleveraging and seeing rising interest rates, and China to hopefully see a big increase in domestic consumption. In the interim, we expect the US economic situation to worsen. For the moment, any improvements are magnified by hope, but frankly, the US/West is seeing a bear market rally, and not real improvement in economic drivers like jobs.

California as US

And California is basically bankrupt. They are now at the point of running out of cash, and with no budget, and huge cuts needed, California is facing a day of reckoning. California is like a mini test case for the US overall. But with a key exception, as California cannot print their way out of their fiscal nightmare. The US can if it wants.

But when the bond markets turn down on California, with the lowest credit rating of practically any US state, California literally will not be able to pay its bills - an event about 13 days from now. And the US just stated they will not bail out California.

And, the California Democrats and Republicans are feuding and playing a game of chicken with the budget. Schwarzenegger stated he will not do anymore half measures to tide over the budget. If the US won't bail out California, they will run out of money in two weeks. I am wondering what effects that will have on the US bond markets.

What happens when the checks stop?

It would appear to me that this will lead to chaos in California. If lots of welfare and other cuts are made (which are just about unavoidable now) California might just see riots. So then, do we finally see the developing depression in the US spread to outright protests, shutdowns, and riots this Summer? California's critical budget gap could be the impetus.

There is no doubt that such a widespread government shutdown in California will be unprecedented. And, if California is said to be the trend setter for the US, does this mean the US is in for the same later?

Well, with China, Russia and other trade blocks taking aggressive action to create trade finance alternatives in their own currencies with currency swaps, and them talking down the USD, and sending money to the IMF to gain influence, the USD 'game' appears to be on. Is this game the endgame, or a bit premature?

It's probably a bit premature to say the USD will collapse this year in a severe devaluation. But, like California, at some point the US will also become unable to pay its bills. And likely the Fed at that point will just buy everything in sight. That will depreciate the USD. We have barely begun that process this year with the Fed being the last resort for US Treasury sales.

Gold

In the meantime, gold corrected from its near $1000 level recently. The USD never fails to do better than expected. Even so, if the US economy stagnates and contracts, the prop for any USD recovery is weak. Gold is holding its verdict here, waiting for further developments.

But the days of the 'USD as we know it' are numbered. So, where we are now is in a transition phase to a new world economy that will move more and more away from the USD standard. Gold can only benefit over the next years.

However, we feel that a modest mix of USD diversification is called for, not a flight. I personally have this 'comfort level' mix of 25% gold and gold stocks, 50% cash/cash type investment with the other 25% for opportunities that come along. When/if the USD turns back down to 70 or below, we will move more into USD havens. But at the moment, this mix has USD diversification as well as being heavy cash.

Deflation still in big sectors

With deflation in the real estate markets and some other areas, there will come great buys in the next year or two - if you have cash. I do not consider only gold as the haven of choice. At some point, in the deflation in the US/West there will come incredible buys in quality assets here - and that is a good place to plan on putting your money into, for a USD devaluation.

But, we are only now beginning the USD endgame, and its only the first quarter in the game. Being liquid and having a 25% metal hedge and cash is a very flexible position to be in now.

Commodities

I continue to feel that base commodities are not the best USD havens. If/when the USD does have a devaluation episode of say 20 or 30 pct in a couple months period, the resulting economic damage is sure to overcome any flight into the commodity complex as a USD haven. Economic demand is far greater than speculator commodity interest.

And, a slowing US/Western economy in the coming quarters is sure to cool speculator interest in the general commodity and probably oil complex.

I feel gold and gold stocks (Silver and Platinum too) will be an exception and continue to hold up well, albeit with that vexing gold stock volatility. Other than that, cash is a good place, with the understanding that when inflation rears its head in the US/West again you will want to move more into USD havens. Right now, deflation in many sectors is supporting the USD.

It is also time to start looking at some currency alternatives. We are looking into these and at some point suggest getting about 25% of your cash type assets into a mix of USD hedges in something like the Yuan or some others. However, until the USD makes clear signs of a break into the low 70 range, its probably premature to make huge moves into USD alternatives as of yet. Deflationary forces are still very much alive world wide.

So, we continue to monitor the situation looking for any major break in this holding pattern with the USD hanging around 80 on the USDX.

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Copyright 2009

Christopher Laird

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Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter and alerts, are general market commentary only. They are not intended as specific advice. You should talk to your own investment professionals for specific advice. Information here is deemed reliable but should be verified by you if you think it's important.