Money Morning Mid-Year Forecast: The Dollar Headed for Some Change 

[Editor's Note: This dollar preview is the latest installment of a new Money Morning series that will make economic projections for key U.S. sectors for the last half of 2010. As part of that series, look for forecasts for the U.S. economy, China, and other emerging markets.]

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 east of the Atlantic and the specter of unsustainable growth and potential inflation on the Pacific side of the globe, savers and investors fled European and Asian currencies for the relative safe haven of the dollar.

As Keith Fitz-Gerald, Money Morning's Chief Investment Strategist, pointed out last week (June 10), from January through May, the dollar gained ground against all but two of the world's leading currencies - China's yuan and the Japanese yen - and it retained parity with them. The greenback appreciated by as much as 16% versus the struggling euro, which last week (June 8) briefly dipped to a four-year low below $1.20, and 13% against the British pound.

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, those who insist on putting their dollars into dollars at this stage should be on the lookout for change, as well as the possibility all they'll get back is change - 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 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, as well as bolster the European and U.S. stock markets. Both 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.

Rising debt here at home is also working against continued strength for the dollar. Not only is the federal government burdened by roughly $14 billion in outstanding debt, but 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 devalues the dollar by its very definition.

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

As Fitz-Gerald noted in last week's article, the combination of low U.S. interest rates and debt-driven inflationary pressure already has foreign banks - especially China's - actively diversifying away from U.S. dollar reserves and dollar-denominated securities. While Fitz-Gerald says the foreign bankers won't "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 among the EU's weaker members is also showing up in the U.S., but here it's states and municipalities rather than countries at risk of going under. 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 picture of the future, the town of Central Falls, R.I., was even placed in receivership in May after city leaders declared it insolvent.

While more news of this nature is unlike to have a direct, short-term impact on the dollar, it will provide an ongoing reminder to both currency traders and foreign governments regarding just how weak the currency's underpinnings actually are - and 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 the charts showed 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.

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 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% or 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, in conjunction with Deutsche Bank, 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 US 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 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 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 euro and the British pound, against which it scored the biggest gains earlier this year, or the leading Asian currencies - 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. 

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