After a Strong First Half, Is the U.S. Dollar Headed for a Reversal?

[Editor's Note: This midyear U.S. dollar forecast is the latest installment of a new Money Morning ongoing "Midyear Forecast" series that will make economic projections for key global-economic sectors for the last half of 2010. As that series continues, look for forecasts for the U.S. economy, China, and other emerging markets.]

Email

In spite of an assortment of economic uncertainties at home, the U.S. dollar has been the star of the currency world for most of 2010. Spooked by persistent and seemingly insurmountable debt problems in the European Union – and the specter of unsustainable growth and potential inflation in China – investors fled European and Asian currencies for the perceived relative safe haven of the dollar.

But the U.S. dollar may have topped out.

Let me explain …

Major Gains for the Greenback

Money Morning Chief Investment Strategist Keith Fitz-Gerald recently pointed out that, from January through May, the dollar gained ground against all but two of the world's leading currencies. The only exceptions were the Chinese yuan and the Japanese yen – and the dollar retained parity with them. The greenback appreciated by as much as 13% against the British pound and 16% versus the struggling euro, which as of June 8 briefly dipped to a four-year low below $1.20.

Money Morning Mid-Year Forecast
The InterContinental Exchange's (ICE) U.S. Dollar Index (USDX), which measures the dollar's value versus a trade-weighted basket of six leading foreign currencies, climbed from a low of 76.732 on Jan. 14, 2010, to an intra-day high of 88.586 on June 8.

However, it's time to be on the lookout for change – caution should be the watchword. Those who insist on putting their dollars into dollars at this stage, could end up getting change in return – the coin type, that is.

That's because a number of signs – both fundamental and technical – indicate the dollar may have seen a top, at least for the near term.

For starters, the European situation improved on Monday when Moody's Investors Service (NYSE: MCO) finally downgraded Greece's much-maligned government bonds by four classes to the junk ranking of "Ba1," deeming the outlook for the new ratings as "stable." While that might not seem like good news for Europe at first glance, it actually is because it validates the recently adopted Eurozone/International Monetary Fund (IMF) support package for Greece. According to Moody's, that package "effectively eliminates any near-term risk of a liquidity-driven default (by Greece) and encourages the implementation of a credible, feasible and incentive-compatible set of structural reforms."

That should provide support and stability for the euro versus the dollar, while also bolstering the European and U.S. stock markets. Both markets have been hyper-jittery for months, rising one day on hopes of a Greek solution, then failing sharply the next on fears the latest proposals wouldn't work and the debt crisis would spread across the continent, perhaps destroying both the European Union (EU) and the euro.


Trouble Looms

Rising debt levels here at home also are working against the dollar's continued strength. It's not just that the federal government is burdened by roughly $14 trillion in outstanding debt. It's also the fact that increased spending demands linked to efforts to stimulate the economic recovery will further drain resources that would otherwise contribute to increased national productivity and a renewal of sustained growth. That, in turn, will contribute to growing inflation, which – by definition – devalues the dollar.

That will likely show up most dramatically in the dollar/euro relationship, since the U.S. Federal Reserve may have to further ease its policies if the recovery falters. At the same time, the European Central Bank (ECB) will stick to the more-prudent monetary policies it has adopted to battle the sovereign debt crisis.

As Money Morning's Fitz-Gerald noted in last week's article, the combination of low U.S. interest rates and debt-driven inflationary pressure already has prompted foreign banks – especially China's – to actively diversify away from U.S. dollar reserves and dollar-denominated securities. While Fitz-Gerald says the foreign bankers won't summarily "dump" the dollar, sending it sharply lower over a short period of time, the declining demand will surely erode its value, gradually but steadily in the months ahead.

A pattern of sovereign debt problems – similar to those being experienced by the EU's weaker members – is now appearing in the U.S. market. But there's one slight difference: Here in the United States, it is states and municipalities – rather than countries – that are at risk of implosion.

California and several other states are already technically bankrupt – cutting back sharply on essential services from schools to roads, as well as on social services. And a number of cities, including Detroit and Harrisburg, Pa., have had their municipal debt lowered to junk status.
In what may be a glimpse of the future, the town of Central Falls, R.I., was even placed in receivership in May after city leaders declared it insolvent.

Currency Market Currents
Additional news of this nature isn't expected to have a direct, short-term impact on the dollar. But it will remind currency traders and foreign governments alike that the greenback's underpinnings are weaker than they seem. There's also the possibility that a cascade of municipal and state defaults could spread to the federal level.

Technically, the dollar has been strong and showing good momentum for some time, but an end to that trend may have been signaled last week when technical-analysis charts displayed a trading formation called the "rising wedge" – a widely recognized bearish signal. This is not the place for a lesson in technical analysis, but historically this pattern has frequently preceded a sharp-price decline, especially when bullish market sentiment has also been strong enough to attract contrarian investors.

How to Invest in a Weak-Dollar Environment

So, if you buy the notion the dollar is ready to head south moving toward autumn and winter, how should you play it?

For the best-funded and most speculative investors, the simplest approach is to short the ICE's Dollar Index futures, or to purchase the related put options, picking contracts that extend out at least three months, the period during which we're likely to see the bulk of any correction.

A second approach is to stay out of currencies entirely, instead investing in "natural" assets such as gold and/or oil, both of which are priced in dollars and thus tend to rise in value when the dollar falls or the pace of inflation picks up.

For most investors, however, the best approach is probably through the purchase of dollar-linked exchange-traded funds (ETFs). Although still speculative – meaning you should limit the size of your investment to just 2% to 3% of your total assets – these funds are highly liquid, have relatively low costs and, in the case of non-index funds, give you the benefit of professional management and analysis.

PowerShares, offered in conjunction with Deutsche Bank AG (NYSE: DB), offers several funds that track the U.S. dollar directly, but the two best suited for bearish plays are:

  • PowerShares DB US Dollar Index Bearish Fund (NYSEArca: UDN), recent price: $24.82: This fund tracks the Deutsche Bank Short U.S. Dollar Index – an index composed solely of short futures contracts. The short contracts are designed to replicate the performance of being short the U.S. dollar against major currencies, including the Japanese yen, British pound, Swedish krona, Swiss franc and the European euro. Founded in 2007, the fund has $254 million in assets, an expense ratio of just 0.57% and has returned 5.19% year to date.
  • PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV), recent price: $22.80: This fund is based on the classic "carry trade." Given the ongoing U.S. policy of monetary easing and ultra-low short-term interest rates, the fund borrows or shorts dollars, using the proceed funds to invest in high-yielding currencies, such as those of Australia and New Zealand. Founded in 2006, the fund has $413 million in assets, an expense ratio of 0.81% (slightly above the category average) and has returned just over 21% year to date.

For those wishing to bet against the dollar relative to a specific currency – most notably the leading Asian currencies, the euro, and the British pound, against which it scored the biggest gains earlier this year – four potential choices include:

  • CurrencyShares Euro Trust (NYSEArca: FXE), recent price: $122.57: This fund seeks to track the value of the euro relative to the dollar (net of expenses), and will rise in value as the dollar declines. Founded in December 2005, the fund has $610 million in assets and an expense ratio of 0.40%.
  • CurrencyShares British Pound Sterling Trust (NYSEArca: FXB), recent price: $147.35: Similar in structure to FXE, this fund tracks the performance of the British pound relative to the dollar, investing in a non-diversified basket of futures and forward contracts. The fund, founded in 2006, has $104 million in assets and an expense ratio of 0.40%.
  • CurrencyShares Australian Dollar Trust (NYSEArca: FXA), recent price: $86.30: Managed by Rydex, as are the pound and euro funds, FXA invests in futures and forward contracts to emulate the performance of the Australian dollar relative to the U.S. dollar. With $700 million in assets and an expense ratio of 0.40%, the fund has returned 29% year to date.
  • WisdomTree Dreyfus Chinese Yuan Fund (NYSEArca: CYB), recent price $24.85: This fund invests in U.S. money market securities and a combination of forward currency contracts and currency swaps in order to create a position economically similar to a money market security denominated in Chinese yuan. Founded in 2008, the fund has $440 million in assets, an expense ratio of 0.45% and has returned a negative 1.62% year to date.

If you don't like those currencies or have a special interest in another country, there are now more than 100 currency ETFs traded in markets around the world, so you should be able to find one that suits your specific portfolio or investment interest.

News and Related Story Links:

Join the conversation. Click here to jump to comments…

  1. Florian Lemphers | June 22, 2010

    There is a significant mistake in the article. It says " Rising debt levels here at home also are working against the dollar's continued strength. It's not just that the federal government is burdened by roughly $14 billion in outstanding debt."

    The number should read $14 trillion which is a significantly larger number.

  2. paramjit garewal | June 23, 2010

    analytical and compelling reading

Leave a Reply

Your email address will not be published. Required fields are marked *

Some HTML is OK