Three Ways to Play the Dollar's Current Spiral

By Martin Hutchinson
Contributing Editor

When some commentators see how steadily the U.S. dollar has declined against a basket of key world currencies, they've labeled it the "death spiral" of the greenback.

They couldn't be more wrong.

To the U.S. economy and to investors in U.S. companies, the dollar's current spiral is much closer to a strand of DNA - the spiral of life.

Let me explain.

Federal Reserve Chairman Ben S. Bernanke and the U.S. central bank have aggressively cut interest rates, sending them down below the rates of other major global economies and below the rate of U.S. inflation. As long as interest rates remain below those two levels, a number of things will happen:

There are three possible alternatives the Fed and the U.S. Treasury might take in response to the dollar's decline:

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  1. Raise Interest Rates: In the long run, raising rates will be necessary to get control of inflation. But the longer the Fed can delay ratcheting up the Federal Funds rate, the more likely it is that house prices will first have time to bottom out, restoring confidence to mortgage holders and the debt market. Raising rates sharply would immediately boost the value of the greenback, but may well cause a sharp economic slowdown. It would be much better if we could avoid that slowdown coinciding with the current meltdown in the bond markets, so it's best to hold off on this idea for now.

  2. Intervention: A second option would be to "intervene" in the foreign exchange markets to increase the value of the dollar against other currencies. This could be done without raising the Fed Funds rate and, ideally, the Fed would not be acting alone in this intervention. Other central banks, most notably those in Europe and Japan, would also want to push up the dollar in order to improve margins for their own suffering exporters. There are reports that central banks around the world could be part of a joint-intervention effort.

    But with U.S. interest rates as low as they are currently, intervention would probably be frighteningly expensive. It would mean the U.S. government would essentially be handing free money out to the pretty unsavory tribe of international currency speculators, because with interest rates at current levels, there is no economic reason to buy dollars.

    The U.S. balance of payments is still close to $700 billion in the red, so money naturally flows out of the United States unless foreign investors can be persuaded to buy. Treasury yields are lousy, and foreign investors can generally [except for the Japanese] get a higher interest rate in their own currencies. The U.S. stock market is dropping, and prospects for improved U.S. earnings look, at best, unexciting. Real estate prices and occupancy rates are currently weakening.

    Given all these economic reasons for the dollar to slide, a U.S. government that intervened against it might find itself in the position of the Anglo-Danish King Knut, who placed his throne on the beach and commanded the tide not to come in. Not a good idea!

  3. Do Nothing: The third possible response to a weak dollar is to simply do nothing [all the while possibly maintaining the polite fiction of both President George W. Bush and Treasury Secretary Henry Paulson that the objective is a strong dollar - if they can avoid breaking out in giggles!]. Doing nothing means the greenback would probably continue its gentle decline against other currencies. And for wealthy travelers to Europe, that might be a disaster. For consumers at home, it would tend to increase inflation, but inflation is rising anyway. I doubt a strong dollar could stop it. Exporters would benefit the most, as they find themselves increasingly competitive, and perhaps able to reestablish themselves in markets they had abandoned to European or Asian competitors a decade ago.

    Since the U.S. economy is decidedly weak at the moment, a competitive advantage abroad would in turn be enormously helpful to employment in manufacturing and exportable service industries and by extension to the profits of U.S. companies with large international businesses.

    At the top end, it could even cushion the housing-market downturn, as wealthy European and Asian investors would find bargains in fashionable markets such as California, Nevada and Florida where overbuilding had been most rampant. The trade deficit would continue to decline, making the dollar sounder and reducing the need to attract scarce foreign investors.

    There are few factors more beneficial than a weak dollar in restoring the U.S. economy to full strength. Far from representing an economic "death spiral," a weak greenback represents the DNA spiral that can give the economy new life, especially in exporting sectors. Ideally, the U.S. balance of payments deficit could be sharply reduced and the housing market stabilized before interest rates have to be raised to fight inflation. When rates are raised - and they will be - the dollar will inevitably strengthen. At that point it might indeed make sense to "intervene" against its newfound strength and cushion any domestic recession.

To play this scenario, I would make three recommendations:

  • First, to guard against rising inflation, consider the StreetTracks Gold ETF (GLD). This ETF offers bullion-based pricing without the storage problems and liability of delivery.
  • Second, to profit from the likely rise in Treasury bond yields and decline in prices as inflation takes hold, look at the Rydex Juno Inverse Government Long Bond Strategy C Fund (RYJCX), which is designed to move inversely to Treasury bonds. The fund shorts futures contracts on long-term Treasury bonds, so it benefits when rates rise.
  • Third, to profit directly from the decline in the dollar and the subsequent rise in U.S. exports, consider investing in an American company with strong global sales. The Boeing Co. (BA) is America's biggest exporter, by far. And while it's true the company has hit a bit of a rough patch of late with both its new Dreamliner 787 jetliner and an Air Force tanker contract, don't make the mistake of counting this company out - it is poised to be a big beneficiary from the expansion of the Asian economy, where China alone will need $340 billion worth of aircraft over the next two decades. Also take a look at Nucor Corp. (NUE), the semiconductor manufacturing giant Intel Corp. (INTC), or forest products giant International Paper Co. (IP) which could provide alternatives. 

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