How to profit from a rebound in the dollar
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Associate Editor
David Stevenson Oct 05, 2009
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The US dollar is the world's biggest, most important currency. Yet for years, it's proven to be one of the worst possible places to store your wealth. And in the long-term, its prospects don't look at all healthy.
But in the shorter term, the dollar has now fallen so far that it's starting to look a good bet. It might just be a bit of temporary respite, but there are several reasons to expect a bit of a bounce in the buck.
Here's why – and how you can profit from it...
"The more that Fed Chairmen change, the more they want (unsuccessfully) to kill the US dollar", says blogger 'Tyler Durden' on Zero Hedge. Durden could have added US politicians, too. The US currency has been in broad decline ever since President Richard M Nixon severed its ties to gold back in 1971.
Since then, on a trade-weighted basis, the greenback has lost over 35% of its value (in case you're wondering, a trade-weighted measure is calculated on the level of the country's external business – in other words, it looks at the dollar's strength against the currencies of the countries the US does the most business with).
Clearly, if you'd been holding your assets in dollars for all that time, and you hadn't been 'hedged' – i.e. if you hadn't effectively swapped your dollars into another currency – then your assets would have fallen in value significantly.
What's caused the dollar's problems?
What's caused the problems? You don't have to look too far to find out. At various points in time, the Fed has been guilty of cutting US interest rates too low, causing too much cheap credit to be created. That in turn has sucked in too many imports, running up an ever-larger trade deficit.
And although the latter has improved sharply within the last 12 months, the US government has now become the villain of the piece – by racking up its borrowing to record, almost unbelievably high, levels.
A new fiscal year has just dawned in the US, and the country has begun it in debt to the tune nearly $12 trillion, according to the Bureau of Public Debt. That follows the largest-ever single borrowing increase in a financial year, and is equal to almost 85% of US annual output – the highest-ever peacetime level.
Not only does this mean a lot more dollars sloshing around, it's getting harder and harder to see how the US can get out of the bind it's in. Warren Buffett has been among those warning that the dollar is likely to be devalued further in the longer run.
To date, the US has only got away with letting the dollar drop because of its 'reserve currency' status – i.e. the other countries in the world hold it as the key currency in their foreign exchange reserves.
Yet ultimately, the key to the dollar's fate rests with China, the largest holder of US Treasury bills – over $800bn-worth at the last count. As the dollar has depreciated, China has lost lots of money. It won't put up with this forever, and for a while now has been muttering about doing something about it.
So let's be quite clear here. Over time, we really do believe that "the dollar is doomed", as we explained in Money Morning back in August (Why the dollar is doomed).
Three reasons why the dollar's about to rally
But no market, bear or bull, falls or rises in a straight line. And the US currency may be about to have a rally within that long-term downtrend. Here are three reasons why.
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First, the dollar's near-14% drop over the last seven months has spooked traders so badly, that they've taken out almost as many futures market 'down' contracts on the currency as when a one-year high in such bets was hit in August, says the Commodity Futures Trading Commission.
In other words, lots of people are betting on further falls. On the surface, that sounds bad for the buck. But in fact, this mounting gloom could turn out to be a positive sign. When everyone goes bearish – and has sold out – that's often exactly the time to buy.
Second, one group is certainly doing just that. Over the last three months, developing nations overall acquired even more dollars than during their previous peak-level buying in 2008, says Gary Smith at BNP Paribas Investment Partners. "The precautionary demand for foreign exchange reserves is higher, by a quantum leap", he says. What's more, these countries will want to keep adding to their dollar stockpiles "for years to come", which will boost the US currency. As Capital Economics puts it: "The dollar is still entrenched as the world's dominant reserve currency and the near-term outlook, we believe, is for dollar strength".
Third, the latest economic news coming out of the States isn't very good. Friday's weak data on jobs and manufacturing were just the latest signs that, excluding the artificial boost caused by government spending on the likes of the 'cash for clunkers' car scrappage programme, the US economy is going nowhere fast.
Again that might sound bad for the dollar. But in fact, when investors get the jitters about the lack of US growth, they look to revert to the dollar again as a 'safe haven'. And, as the dollar rises, stocks tend to drop. That's because people stop buying US shares and plump for cash, in dollars, instead. That's bad news for stock markets.
"The global proxy for recovery and investor risk appetite has been the US stock market", says Bryan Rich on The Market Oracle. "And a reversal in recent trends in financial markets bodes well for the dollar".
Many dollar-quoted commodities will suffer too. A rising US currency would mean the prices of those commodities falling. That in turn will hurt the stock market valuations of the resource producers that have driven the big stock market rebound since March.
How to profit from a bounce in the dollar
So how can you cash in on a broad-based bounce in the dollar? You could of course look at taking a short position on the stock market. Riccardo Marzi, the ex-City trader behind our new investment newsletter, Events Trader, last week made a handsome profit by using put options to bet on a fall in the FTSE 100. But while this can be very profitable, it's a risky business, and you can lose your shirt doing this.
A more straightforward alternative is to buy the US-listed Powershares DB US Dollar Index Bullish fund (UUP). This is designed to replicate the performance of holding the US dollar against a basket of these currencies: the euro, the yen, sterling, the Canadian dollar, the Swedish krona and the Swiss franc. You can find details at www.invescopowershares.com. Alternatively, call 0800 983 0903.
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