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.