2012 U.S. Dollar Outlook: How to Play A Short-Term Rally

[Editor's Note: This special report on the U.S. dollar is part of Money Morning's annual "Outlook" series, which forecasts the prospects for stocks, commodities, and other top profit opportunities in the New Year. Our last forecast focused on the U.S. Economy.]

The U.S. dollar will start 2012 on an upswing - but don't let it fool you.

What we're seeing is only a short-term rally inspired by Europe's travails. In the long-term, the U.S. Federal Reserve's loose monetary policy and the United States' own debt burden will drive the greenback back down.

That's the consensus among experts who follow the global money markets and the leading currencies, including several of Money Morning's own analysts.

"The dollar is going to rally in the short-term so long as the primary liquidity mechanism (used by the world's central banks) continues to be dollar swaps," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "How long that is going to last is uncertain - perhaps March, April or beyond - but once it abates, our own enormous debt problems and inflationary policies will return to the spotlight and the dollar will quickly give up its recent gains."

Indeed, the dollar rallied in the second half of 2011, as Europe's debt battle dominated the headlines. The U.S. Dollar Index, which measures the dollar's value against a basket of foreign currencies, ended about 10% higher than its May 2011 lows, gaining almost 3% in November.

That momentum is likely to continue for the first part of the New Year, but not long after.

Several economic factors will weigh far too heavily on the currency for the upward move to continue - although it's not clear exactly when the short-term surge will lose steam. And investors who understand what's really driving the U.S. dollar's value in 2012 can avoid getting burned by the currency's long-term decline.

Short-Term Help from Europe

The U.S. dollar's short-term boost will mostly come from the need to support Eurozone governments with more liquidity.

"The ECB (European Central Bank) will be left with little choice in saving banks and their sorry sovereigns other than to print, print, print euros, and more of something almost always leads to a lower price," said CNBC News' Brian Sullivan, who thinks the U.S. dollar will reach parity with the euro in 2012.

The euro fell to a 15-month low against the dollar in the last week of 2011. It traded yesterday (Monday) as low as $1.2930.

MM 2012 Outlook
U.S. dollar value has also been driven higher recently by increased demand, since the central banks in Europe, the United States, Great Britain, Japan, Canada and Switzerland have all agreed to lower the interest rates on dollar swaps.

"Dollar swaps - you know, those little arrangements that allow foreign banks to swap their unloved currencies for dollars - ... really come in handy when there's a panic and a flight to the safety of U.S. Treasuries," Money Morning Capital Waves Strategist Shah Gilani explained. Since U.S. Treasury securities must be purchased with dollars, increased demand boosts the currency's value.

However, the overwhelming long-term outlook for the U.S. currency is still bearish, mostly due to the weak U.S. economic outlook for 2012.

"The dollar is enjoying a safe-haven status, but long run I'm not a fan of the U.S. dollar," Dr. Allen Sinai, chief global economist at Decision Economics, told Forbes. "Our country has too many problems - with long run growth forecasts, deficits and how the politics of our country operates are all a negative."

Indeed, the dollar's prolonged decline has been supported by the ongoing struggles of the U.S. economy, the ever-growing levels of U.S. government debt, and the misguided "fixes" and other monetary and interest-rate maneuvers by U.S. Federal Reserve Chairman Ben Bernanke and his cohorts.

These influences won't disappear in 2012.

"The Fed will be obliged to undertake another round of quantitative easing and it will be a major source of negativity for the dollar," said Forex.com Chief Currency Strategist Brian Dolan. "The economy has been so slow for so long, it'll force the Fed's hand."

The dollar also faces a growing challenge in its long-standing role as the world's dominant reserve currency from the Chinese yuan. China's been making strides in turning the yuan into a global currency by increasing its role in the gold market and facilitating foreign investment in its currency.

The U.S. dollar's struggles aren't new, but rather have been a trend for about a decade. You can see the dollar's path of decline with the U.S. Dollar Index, a measure of the dollar's value relative to a weighted basket of six major foreign currencies - the euro (58.6% weight), the Japanese yen (12.6%), the British pound Sterling (11.9%), the Canadian dollar (9.1%), the Swedish krona (4.2%) and the Swiss franc (3.6%).

US Dollar Slide
Since 2003, the index has fallen 27% from near 110.00 to just above 80.00. It gained 2.9% in November, but erased those gains in December to break just about even in 2011.

Luckily for investors, there's a way to play both the short-term rally and the long-term fall of the U.S. dollar.

Investing in the U.S. Dollar in 2012

To play the dollar's fluctuating value this year, investors can use a Forex market contract, futures contracts on the U.S. Dollar Index or the dollar versus leading individual currencies, or one of the new dollar-based exchange traded funds (ETFs). For short-term trades, options on either the futures or the ETF shares also can be used.

Investors who opt to play the currency's near-term strength must remember to monitor the events affecting the dollar's value - a buy-and-hold approach won't work.

"Be nimble," said Money Morning's Fitz-Gerald. "Harbor no illusions about what's happening. Capture profits as they're created by maintaining tight trailing stops, and steadily ratchet them up if the rally gains steam."

One of the leading ETF candidates for a short-term bullish dollar play is the PowerShares DB US Dollar Index Bullish (NYSE: UUP). Actually exchange-traded notes (ETNs) rather than a traditional fund, units are issued in 200,000-share blocks by a "master trust" that seeks to replicate the performance of the Dollar Index by holding a combination of Forex contracts, futures, and options. Those shares then trade in smaller numbers, just like shares of regular stocks, and the price mirrors the percentage changes in the actual index.

That's for a short-term dollar play, but you also should plan to profit from its longer-term decline.

One of the best ways to play the long-term bearish dollar outlook is through ETF/ETN shares, like the PowerShares DB US Dollar Index Bearish (NYSEArca: UDN). It's structured the same way as the UUP fund, but the trust holdings include short Forex and futures contracts and options, combined in a portfolio designed to move inversely to the Dollar Index itself, but by a similar percentage.

The alternate way to make a longer-term ETF play against the dollar is to buy shares in one of the growing number of ETFs linked to foreign currencies - depending on whether you believe that particular currency will benefit from the dollar's weakness.

Currencies with their own ETFs currently include the Australian dollar, British pound, Canadian dollar, Chinese yuan, euro, Indian rupee, Japanese yen, Mexican peso, New Zealand dollar, Russian ruble, South African rand, Swedish krona, and the Swiss Franc. Some currencies, like the rupee and yen, even have two funds from which to choose.

For a better idea of which currencies are poised for a strong performance this year, check out the detailed report "The Three Must-Own Currencies of 2012" by Money Morning Global Investing Strategist Martin Hutchinson.

A final option for bearish dollar investors would be to open a bank deposit account denominated in a foreign currency you think stands to appreciate considerably against the dollar in the years ahead. A popular choice for such accounts is Everbank (**), an FDIC-insured Internet bank that offers deposit accounts, money market accounts and certificates of deposit in both baskets of currencies and those of specific nations, including the euro, yen, British pound, Swiss franc, yuan, Singapore dollar and several other major currencies.

(**) Special Note of Disclosure: Money Morning's parent company, Money Map Press, has a business relationship with Everbank.

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