Investing In a Weak-Dollar Global Economy

Investing in a Weak-Dollar Global Economy October 10, 2009   Bill Witherell, Chief Global Economist

Last weekend, in the margins of the G-7 meeting in Istanbul, Treasury Secretary Tim Geithner told reporters that it is “very important” to have a strong dollar and that the US will do “everything necessary” to maintain confidence in the dollar  He acknowledged that this meant getting the US budget deficit under control.  These words are what one expects from a US Treasury Secretary and did not have a noticeable effect on the greenback’s continued swoon.

Monday, October 5, the US dollar was undermined by two developments. The first was the unexpected move by the Reserve Bank of Australia to increase its policy interest rate by 25 basis points to 3.25%. The already strong Australian dollar soared. This signaled the start of a global tightening cycle, as exit strategies start to be implemented.  The first to move will be those where the recession has been mildest and/or the recovery is strongest.  The US will not be quick to follow.  Indeed, the US monetary authorities have given strong indications of their intention to hold short-term rates to close to zero for an extended time.

The Australian rate increase served to underline the continuing interest-rate disadvantage of holding the US dollar. The greenback has reportedly become the currency of choice, replacing the yen, for the so-called “carry trade” (borrowing in a low-interest-rate currency in order to invest in a high-interest-rate currency).

The second blow to the dollar came from unconfirmed reports of a secret meeting between officials of oil-exporting and oil-consuming countries (the Gulf states, China, Russia, Japan, and France) to discuss replacing the US dollar with a currency basket in the oil trade. The official denials following the reports in the press were expected but not completely convincing.  Such rumors are increasingly common when the dollar is weak. Nevertheless, any such move to replace the dollar with a currency basket could not be implemented rapidly. There are considerable practical problems with such an alternative, and no other currency can match the depth and liquidity of the dollar markets. Nor would these countries wish to take actions that would undermine the value of their very substantial US dollar holdings.

Another development that could be contributing to the heavily bearish dollar sentiment was revealed in the latest (2009-Q2) report of the IMF on the “Composition of Official Foreign Exchange Reserves.”  These data implied that central banks are becoming increasingly reluctant to further accumulate US dollars and are slowly shifting to other G-10 currencies.  Central banks are very unlikely to make any drastic changes in this regard, as that would impact seriously on the value of their existing dollar reserves.  However, any evidence that central banks are becoming increasingly averse to holding the US dollar is a negative for the market.

An important structural factor underlying the dollar’s weakness is the massive US budget deficit and liquidity injections by the Fed that could well lead eventually to inflation problems, unless policy makers can manage to move the economy to a more balanced and sustainable track. We do not see inflation becoming a problem in the US for a considerable period, but this concern does appear to be one of the factors weakening the dollar.  Probably of more immediate importance is a cyclical factor, the growing appetite for risk on the part of investors as the recovery in the global economy becomes more evident. Flows to the US dollar (short-term Treasuries) as the only place to hide at the height of the financial crisis are being unwound. 

We do not see an early reversal of these factors.  Direct intervention in the exchange market by the US Treasury is very unlikely, and the Fed is not likely to advance its timetable for beginning to raise short-term interest rates in order to support the dollar. Fed Reserve Chairman Ben Bernanke’s statement that the Fed will ease monetary policy when the economic outlook shows sufficient improvement appears to behind the covering of some short dollar positions on Friday, October 9th.  This followed the fall of the currency to a 14-month low on Wednesday. The statement of the obvious did not imply an early rate rise to support the dollar.  There also was some intervention Thursday by a number of Asian central banks (South Korea, Taiwan, Thailand, Indonesia, and Hong Kong).  This move appears to have been motivated by a concern that the appreciation of their currencies is making their exports increasingly uncompetitive, particularly in comparison with the Chinese renminbi, which has been pegged to the dollar since July of 2008. Such intervention may slow the appreciation of these currencies somewhat, but no one thinks this can reverse the dollar’s decline. Intervention by the European Central Bank or the Bank of Japan potentially could have a greater impact, but neither seems likely to intervene as long as the currency markets remain “orderly.”

At Cumberland Advisors, we have positioned our international portfolios for a continuation of US dollar weakness.  In our Global Multi-Asset Class ETF portfolio, we have long positions in the currencies of two major commodity-producing countries, the Australian and Canadian dollars. More importantly, the portfolio is underweight US, UK, and Japan equity ETFs and overweight Australia, Canada, Euro zone, and emerging-market equity ETFs.  It is noteworthy how much US dollar-denominated returns from international investments have been helped this year by the dollar’s decline.  For example, the benchmark equity index for advanced-economy markets outside of North America, the MSCI EAFE Index, is up year-to-date by over 24% in US dollar terms, some 50% more than the 16% increase in local-currency terms.  Of course, this effect will reverse when the US dollar eventually recovers.  We will be looking carefully for advance indications that the greenback’s decline has come to an end. We fear that wait could be a long one.

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