Considering a Dollar Decline

As the U.S. financial crisis rippled outward to the larger global economy, and as the plight of other nations dwarfed that of our own, an increasing number of Americans and foreign investors have poured resources into the U.S. dollar. The resulting bounce has helped our native currency recoup more than two years’ worth of losses, according to the Wall Street Journal, while the dollar has strengthened 23% against the euro and 34% against the British pound since early August. Such a rally inevitably begs the question of its sustainability, and as analysts cast doubt on the future of the dollar gain, ETF investors have shifted interest from PowerShares DB U.S. Dollar Index Bullish (UUP) to PowerShares DB U.S. Dollar Index Bearish (UDN). While the U.S. experiences a relative calm in its equity markets, or basks in the eye of the hurricane, a new—more bearish—dollar view may be in order for investors.

UUP and UDN both sit atop the Sector Momentum Tracker International Momentum Table, holding the third and fourth positions, respectively, as of December 15. The increase in momentum has been a result of rapidly changing conditions for the U.S. dollar in 2008. With the dollar dropping 7% since Thanksgiving, many formerly bullish dollar investors are beginning to hedge their bets for the new year with rising UDN.

While one might hedge the dollar’s decline by directly buying the currencies of other nations, UDN offers the flexibility of getting a diversified short dollar bet in one place—with the availability of intraday trading on home turf. UUP and UDN allow investors to make long and short bets, respectively, on the direction of the dollar. Both the long bet, UUP, and the short bet, UDN, utilize futures contracts tied to the U.S. Dollar Index. This index measures the dollar against a basket of six other currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. Relative strength in the dollar boosts UUP, while weakness strengthens UDN.

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Some analysts have argued that the fall of the dollar, and the subsequent rise of UDN, is imminent; others believe that the dollar rally may still have legs into early 2009. “We are roughly halfway through the rally in the dollar,” said Stephen Jen, global head of currency research at Morgan Stanley, in early December. Jen also predicted a dollar decline in the second half of 2009 as the full ramifications of recent bailout programs become evident.

The decline of the dollar would have both positive and negative effects on individual investors and the economy. The recent boost in relative valuations has allowed many Americans to travel abroad at a more reasonable expense—a trend that would ultimately reverse if the dollar were to weaken. At the same time, a weaker dollar would be a boon for U.S. exports, making them more competitive with similar products manufactured abroad.

The task for investors and analysts alike will be to determine the effect that the expanded Federal Reserve balance sheet will have on the dollar as the market improves. The Fed in recent months has faced the task of walking an increasingly thin line between the threat of deflation and that of inflation. Many believe that the massive cash injections into the economy will prove inflationary, eroding the value of the dollar and boosting the value of short bets like UDN in 2009. Others contend that the Fed will be as aggressive in raising rates as it was in cutting them in order to stem inflation—a daunting task, at best, in bleak economic conditions.

If the dollar continues to slide, investment opportunities like UDN will help put investors on the right side of the curve. A decline in the dollar could also spur Amer- icans to purchase foreign stocks once again, a trend that has decreased dramati- cally as market conditions at home and abroad deteriorated and as returns were diminished by conversion rates. A drop in dollar value would also benefit compa- nies doing business both in the U.S. and abroad. These companies have seen a decline in profits as they convert other currencies into a stronger dollar—a trend that would reverse if the dollar weakens.

Those who continue to back the dollar argue that the U.S. situation will continue to look rosier than problems abroad. If the current financial crisis continues to erode economies abroad at a faster rate than it does the market at home, many argue that the dollar will continue to show strength against currencies such as the yen. Other investors in products like UDN, however, are willing to bet that some of the aggressive measures taken by the U.S. government will produce some sort of slow rally and a fall in the dollar. Both theories hinge on predictions concerning the duration of the economic crisis and our current position in it—an issue that both UUP and UDN fund holders will have to contend with in upcoming months.

Comments

[Ben Pottker:]

I sold my UUP position a few weeks ago (not at the top). I didn't turn around my position to DWN, which I should have. However, I am not at all sure that we have seen the end of the $ rally which started in August. Generally, at the end of the year, the $ weakens for seasonal end-of-year reasons. Thsi was clearer in the 1980's and 1990s but I believe that a similar movement is happening now. Therefore, I wait a week or two to see what happens early 2009.
Best regards,
Ben Pottker

2008 Dec 18 03:11 PM

[bosun.j:]

Two words in the last paragraph jump off the screen.

products and theories.

Products, a word to describe something produced. Banksters don't have products they have marketing ploys. They make up imaginary stuff and and then make up more stuff to sell that made up imaginary stuff.

Theories. All that is being offered here is the obvious. There are two theories that this article recognizes. Both result in commissions that can be made.

Sure, this is a blog that accepts these "products" are worthy and perhaps even honorable. Keep your powder dry.

At the end of the day all that's really going on here is allot of running around rearranging the deck chairs on the Titanic in a futile attempt to put more zeros on a ledger. A ledger that will be meaningless when the collapse finally becomes total.

2008 Dec 18 03:39 PM

[Chris B:]

2 Observations:

1) What happened to the dollar's value in the late 1940's when all the excess liquidity that had been injected to end the depression was mopped up? What happened to inflation, even as massive amounts were spent to implement the Marshall plan? Keep in mind that government debt in those years reached debt-to-GDP ratios that have never been seen since and that we hopefully won't reach even with the bailouts. The answer is, it fluctuated, reaching high levels after WW2 as rationing and militarization of industry ended and not enough consumer goods were available to meet demand and going into brief deflation in 1949 as contractionary policies kicked in.

www.clevelandfed.org/r...

2) The ONLY reason to own treasuries yielding near 0% is if you think the dollar will appreciate against your home currency (or at least not crash like your home currency will). Americans aren't buying these no-yield treasuries - not when they can get 3-4% out of a diversified basket of FDIC insured online savings accounts and CD's. Foreigners are betting on massive US deflation and continued appreciation of the dollar. They are also hiding from other currencies.

What would happen if developments indicated that the US dollar was not going to outperform the yen, euro, pound, peso, Canadian or Aussie dollars? Capital flight perhaps? Seen the yield on the Australian dollar lately?

2008 Dec 18 03:46 PM

[Cjhies:]

A dollar decline along with the yen is inevitable as India, China et al grow to make up a larger part of the global economy and deminish the % of the total world market we make up as consumers and producers. The decline would have already started if the Chinese would not be pegging their currency to ours.

Once they remove the peg, their goods will become more expensive and help shrink our defecit which will strengthen the dollar. But in the long haul our influence on the world economy should slowly decline. However, if our politicians and economists play the cards in a fiscally conservative manner, our role as safe haven & innovators in the world economy

2008 Dec 18 06:42 PM

[E Nuff Sed:]

Given that treasury yeilds are still falling I'd say the USD rally still has legs.

2008 Dec 18 09:37 PM

[Asbytec:]

I hope you're right, Nuff...a lot of exporters are counting on it. But, I'm afraid after this is said and done, we won't be consuming as much.

Even Greenspan predicted the US will still be the world's largest economy in 20 years, just consuming less...maybe producing more.

2008 Dec 19 09:15 AM

[otbricki:]

20 years from now production costs in the rest of the world will have equalized with the US and shipping costs due to increased energy prices will bias manufacturing towards local production.

2008 Dec 19 01:15 PM

[Asbytec:]

Otbricki, so you're saying China will have a burgeoning middle class demanding higher wages and maybe some labor unions? :)

But, by then, the price of hydrogen will have stabilized. (Don't I wish...) :)

2008 Dec 19 11:13 PM

[Kunst:]

Greenspan, sounds familiar. The Oracle, right? Perfect foresight, pinpoint predictions. Yeah, I remember him.


On Dec 19 09:15 AM Asbytec wrote:

> I hope you're right, Nuff...a lot of exporters are counting on it.
> But, I'm afraid after this is said and done, we won't be consuming
> as much.
>
> Even Greenspan predicted the US will still be the world's largest
> economy in 20 years, just consuming less...maybe producing more.

2008 Dec 21 03:15 PM

[johnthegeni...:]

He says the dollar will "continue" to show strength against the yen.

Reality check: the dollar is falling against the yen. Down about 25% in the past two years.




On Dec 21 03:15 PM Kunst wrote:

> Greenspan, sounds familiar. The Oracle, right? Perfect foresight,
> pinpoint predictions. Yeah, I remember him.

2008 Dec 30 06:13 PM