How to Protect Yourself from a Falling Dollar

If you believe that printing and/or borrowing $13 TRILLION dollars could just be, as the old Levi’s ads used to say as a euphemism for “fat”, a “skosh” more inflationary, then I have a relatively conservative way for you to protect yourself, and perhaps profit, from that sad fact.

(By the way, the word “skosh” was borrowed from Japan, from whom we have borrowed much more than merely words in recent years; it is, after all, a close second to China in holding U.S. government debt. In Japanese “sukoshi” means “a little bit.” Word researchers believe American servicemen based in Japan brought it back following WWII. They’re right. My Dad, stationed in Japan in 1951, used it all the time, even before he might have needed a skosh more room in his Levi’s…)

So how do you protect yourself? You can buy gold, as many have done. You could buy basic commodities like grains, oil, or metals necessary to keep the world transporting, electrifying, and so on. You could try to determine who has enough pricing power to keep pace with inflation because they enjoy a near-monopoly or a product so essential that people will use more of their declining dollars to possess it. You could buy a "dollar down" ETF like PowerShares DB U.S. Dollar Bearish Fund (UDN). Or, since the dollar is declining not in absolute terms against a worldwide standard but against other currencies, and as the dollar declines, in dollar terms those other currencies will rise, you could simply buy them.

Buying foreign currencies used to be a dicey thing. I’ve traveled to some 80 countries in my military and civilian careers and, like some of you, I still have memories of standing in line at foreign banks while the teller slowly inspected each U.S. bill I handed them, charged me some usurious fee to exchange them into a wheelbarrow full of their (then not nearly as sound as the U.S. dollar) currency, which I rushed to spend on something that wouldn’t decline as rapidly as what I had in the wheelbarrow. The local libations of choice usually provided both succor for my problem as well as an expeditious way to stave off the decline in the currency.

Investing in “forex” (foreign exchange) wasn’t much easier. While no one was going to helicopter over your home and dump 10,000 pork bellies onto the lawn, the process was still cumbersome, time-consuming, and very profitable for the myriad middlemen who assisted you in purchasing futures or options on other currencies. But nowadays there is a much easier and cheaper way to invest some of your money in other currencies.

For decades, we’ve been able to buy companies headquartered in other nations whose profits accrued in a different currency. Buying Toyota (TM) or BP or Nestle’s (NSRGY.PK) would have given you some protection against a declining dollar since these firms’ revenues ultimately accrued in, respectively, Japanese Yen, British Pounds or Swiss Francs. But they didn’t give the direct protection that actually owning a currency stronger than, or on a different track than, the U.S. dollar, could provide. Enter currency ETFs and ETNs.

Rather than give a redundant explanation of these instruments here, let me instead refer you to this article. The SA editors have done an outstanding job of briefly explaining the product, providing a directory of further readings, and listing 35 different ETFs and ETNs, all of which typically charge no more than a half-percent or so a year. These are products with low frictional trading and holding costs.

A personal bias / caveat: By and large, I don’t trust ETNs. Unlike ETFs, which actually purchase stocks or commodities and futures, ETNs typically start with futures and then get just a little too fancy for my footsteps in creating more exotic derivatives that allege to deliver the same returns “as if” they’d held the underlying stocks or physical commodities. You are relying upon the cleverness of the bankers / brokers issuing the ETN and their deep pockets to make you whole if the ETN doesn’t work out. If you want to trust the brainpower and financial health of Bank of America (BAC), Citicorp (C), UBS, et al, that’s your business. I've seen little demonstration of either lately.

What currencies and ETFs do I like best? Any that do not trade in lockstep with the US dollar. Rather than research arcane data to then speculate on how much or little a nation will trade with or use the U.S. dollar to settle transactions, you might first consider a basket of other currencies. One that just hit my inbox and began trading yesterday is the Wisdom Tree Dreyfus Emerging Currency Fund (CEW).

I am not a great fan of most emerging markets. By analogy, I’d rather buy the nations that sell the picks and shovels to the gold miners than back a gold miner who either starves, gets by, or, once in a blue moon, strikes it big. (After the last of our print subscribers have received their copy tomorrow, I’ll post on our InstaBlog the current Investor’s Edge ® article on this subject, The BRICs are OK, But the ABCs are Better.)

However, in this case I think Wisdom Tree is on to something. Their analysts will select and then equal-weight up to 12 emerging market currencies, like those of China, Turkey, Israel, Brazil and South Korea each quarter, rebalancing the next quarter. On average, a basket of emerging market currencies like this will have just a 0.68 correlation to U.S. stocks and a 0.20 correlation to U.S. bonds. And the funds invested should enjoy a greater interest and dividend yield than they would in the U.S. dollar, as well. Looking at the chart below, I’d say this may be an opportune time to consider alternatives to the dollar.

In addition to CEW, there are two specific currency ETFs I like. I see Canada and Australia as breadbaskets, metals providers, and energy providers to the world. For the long term, I believe these two currencies will reflect the rising status of both nations as the world queues up to buy what they grow, mine, and drill for. CurrencyShares Australian Dollar Trust (FXA) and CurrencyShares Canadian Dollar Trust (FXC) are good ways to participate. As uninformed sellers rush to sell these based upon the illusion that the U.S. recession has ended and the U.S. dollar will rally, I’ll be buying both.

A final note on the last sentence above. As I wrote in Credit Cards: From Dining Convenience To Eating Our Lunch (published on our InstaBlog, not yet selected by SA Editors for wider distribution) “One of the reasons I can’t get too excited about the prospects for our current rally to carry much above where it is today is that the ‘credit card’ shoe has yet to drop. Subprime was the first blow, CDS’s another. Alt-A has yet to get its full licks in, and "developing world" debt as well as commercial real estate refinancing are both lurking around the corner. But it’s credit card debt that could really deliver the knockout punch to any rally this year.” For all these reasons, today’s less-than-last-month unemployment, and banks jiggering the books to meet lessened-expectation earnings, are hardly grounds for celebration. It’s time to begin diversifying away from the U.S. dollar to protect ourselves and allow us to buy dollars back cheaper once this temporary insanity passes.

DISCLOSURE: Long a pilot position in CEW, buy limits entered on FXC at 81, FXA at 69 and UDN at 24.20.

Comments

[dcb:]

As many countries lower interest rates (it appears that is still going on) you may get inflation but relative stability between currencies. hard assets takes care of that. But I think just the way out of the dollar was they way to go before this crisis it will be the way to go again.

May 07 08:33 AM

[bricki:]

At the end of the day fiat is fiat. I'd be looking to buy the real stuff people need for their daily lives. It's depressed now because economic activity is low.

May 07 09:50 AM

[Bull Run:]

Don't be too quick to knock America's manufacturing comp. As the US dollar drops imports become more expensive, and that means "good old made in America" may have a come back.. I like Ford,and agriculture maufacturing products,Agco and John Deere (as commodity rises), because of the dollar effect. A cheap dollar may well boost American products sold in America, but also Cat because it needs a cheap dollar to help it's big export market.

May 07 10:58 AM

[Just Say Whoa!:]

>Isn’t the USD already hyper-inflated relative to other currencies given that the notional $700 trillion derivatives market and another $360 trillion in credit markets are mostly dollar denominated?

No. Because the USD is the world's reserve currency.

Bernanke will suck those dollars out of circulation, once the economy starts taking off again.

Don't worry kids, adults are in charge now--unlike the past 8 years.

May 07 11:16 AM

[sunnsea:]

Good post. There real economy has grown very little since then. 1998 is the key level for everything including real estate. All values must be restarted from there and then factored up by whatever the CPI was annually. Since inflation, except for the real estate bubble, was low, there should be about a 10% gain in value on most assets since 1998 to now.


On May 07 06:39 AM pragmattist wrote:

> Isn’t the USD already hyper-inflated relative to other currencies
> given that the notional $700 trillion derivatives market and another
> $360 trillion in credit markets are mostly dollar denominated?<br/>
>
> Depending on loss provisions based on expectations of how bad things
> will get (defaults, interest rates), those "insurance" policies in
> the notional $700 trillion derivatives market represent $15 -$60
> trillion in credit risk. That is real money, and it is evaporating
> as we type. Normal credit markets are also contracting faster than
> the Fed can print.
>
> Wouldn't the deleveraging process underway in these markets only
> deflate the USD, as the Fed can never print enough money (which by
> the way does not require a buyer) to offset the hundreds of trillions
> of USD deleveraging? Though the Fed is surely trying.
>
> Wouldn't there be a strong USD vs EUR simply because there is more
> demand for the USD to deleverage USD denominated debt than demand
> for EUR to deleverage EUR denominated debt?
>
> Doesn't the Fed have more flexibility than the ECB (endogenous QE
> only) to increase or decrease its balance sheet? Couldn't the EUR
> get stuck in inflation (if they are able to contain deflation first)
> a lot easier than the USD from quantitative easing due to that lack
> of flexibility?
>
> How can any central bank allow high inflation or stagflation? Wouldn't
> the notional $500 trillion in interest rate swaps cause a crisis
> that would make the 2008 notional $60 trillion CDS crisis look like
> child's play? Wouldn't central bankers sell their gold before they
> let that happen?
>
> It seems to me that central bankers are indeed walking a tight rope
> between 0 and 2% inflation, but the USD can only gain in relation
> to other currencies as the deleveraging process brings us back to
> 1998 levels of GDP. 1998 being the year before Clinton and Congress
> repealed the Glass-Steagall Act.

May 07 11:17 AM

[cihat:]

Forex allows you to deposit 1000 USD and buy or sell 200000USD (leverage 200 times) worth of gold/currency with it.
As more and more Forex brokers are adding Gold among their instruments, I expect at some point there will be more paper gold traded up or down, than the physical gold available.
I wonder if 150 USD oil purchased ever existed in that quantity.

May 07 11:32 AM

[nobby73:]

I'm afraid you don't understand the derivatives market. The $700 trillion notional is no indication of the credit risk in the market, as most trades are offsetting and the major counterparties collateralize most positions.

If for example a bank if receiving fixed $100mm 1 yr interest rate swap starting, it will probably hedge paying fixed on a strip of futures contracts, so the total notional will be $100mm for the payer +$100mm for the receiver, plus $400mm of futures for the hedge plus $400mm futures for the hedge provider. Therefore, one $100mm swap creates a $1 billion notional of trades. Add to that many banks have huge portfolios of long and shorts, the net risk position is much smaller.

In the recent bank results, there is a detailed breakdown of CVA, which gives an idea of the credit risk of their derivative books.


On May 07 06:39 AM pragmattist wrote:

> Isn’t the USD already hyper-inflated relative to other currencies
> given that the notional $700 trillion derivatives market and another
> $360 trillion in credit markets are mostly dollar denominated?<br/>
>
> Depending on loss provisions based on expectations of how bad things
> will get (defaults, interest rates), those "insurance" policies in
> the notional $700 trillion derivatives market represent $15 -$60
> trillion in credit risk. That is real money, and it is evaporating
> as we type. Normal credit markets are also contracting faster than
> the Fed can print.
>
> Wouldn't the deleveraging process underway in these markets only
> deflate the USD, as the Fed can never print enough money (which by
> the way does not require a buyer) to offset the hundreds of trillions
> of USD deleveraging? Though the Fed is surely trying.
>
> Wouldn't there be a strong USD vs EUR simply because there is more
> demand for the USD to deleverage USD denominated debt than demand
> for EUR to deleverage EUR denominated debt?
>
> Doesn't the Fed have more flexibility than the ECB (endogenous QE
> only) to increase or decrease its balance sheet? Couldn't the EUR
> get stuck in inflation (if they are able to contain deflation first)
> a lot easier than the USD from quantitative easing due to that lack
> of flexibility?
>
> How can any central bank allow high inflation or stagflation? Wouldn't
> the notional $500 trillion in interest rate swaps cause a crisis
> that would make the 2008 notional $60 trillion CDS crisis look like
> child's play? Wouldn't central bankers sell their gold before they
> let that happen?
>
> It seems to me that central bankers are indeed walking a tight rope
> between 0 and 2% inflation, but the USD can only gain in relation
> to other currencies as the deleveraging process brings us back to
> 1998 levels of GDP. 1998 being the year before Clinton and Congress
> repealed the Glass-Steagall Act.

May 07 11:36 AM

[user396040:]

I generally agree. Many investors don't realize that over the past year the dollar is actually up against most currencies - including the currencies of some of our most important trading partners(Canada, Mexico, Brazil, UK). I think the dollar is due to go down and a decline would be beneficial to the economy(it would enable American business to compete more effectively in both the import and export markets). One problem is that whenever there is an international crisis, regardless of the macroeconomic impact, the dollar tends to go up drastically because of the "security blanket" factor. We also must recognize that other currencies are based in parts of the world where the neighborhood could be described at best as sketchy and at worst as dangerous(e.g., Japan and North Korea, Europe and the Middle East) and such currencies could quickly tank due to an adverse geopolitical development. Finally, any reader of these boards quickly realizes that the American public is much less inclined toward collectivism than the publics of Europe, UK, Japan, etc. and thus the US will always be viewed as somewhat of a "safe haven" for wealth. Add it up, and there are a number of factors having nothing to do with trade balances which artificially inflate the dollar. The Fed is doing its best to counteract this with expansive monetary policy but it will always be a tug of war.

May 07 01:12 PM

[Thomas J. G...:]

I can't tell if the author is down on the rydex currency funds or not. I had a really good experience with them. fxy and fxf were one of the few things I owned in fall to end 2008 that went up in value.
user402764 - i wrote an article about gold etf's becoming private money. they are bad private money because gains on gold are taxable. i wrote another article suggesting that gold and silver be exempted from capital gains, giving them money like status, which seeking alpha didn't publish.

May 07 01:14 PM

[Bar Lock:]

Good article, but I wish Schaefer spent more time analysing the downside risk associated with these different strategies especially the emerging market currency funds.

May 07 01:25 PM

[Bad Dog:]

I have been buying foreign 3-month CD's, just going where the interest rates are. Since the USD is over-valued right now, I can earn better returns for modest risk, assuming the the USD will correct at some point, which will allow me to "repatriate" the principal. That's my hedge against a falling USD.

May 07 02:25 PM

[user396040:]

Soooo - which way do you think the dollar is going to move in the next 30 days?

May 07 04:07 PM

[Living4Divi...:]

Excellent article ! I just wrote an article in a a similar vein on SA, titled "The Dollar Is Doomed" But - I came to different conclusions then you did about remedies for investors. I believe that no fiat currency is a safe haven - but the dollar is the least safest of the majors. Certainly if you want/need to hold currencies - it is better to be diversified into other currencies than the dollar.

May 07 05:13 PM

[Ad Orientem:]

I concur with the view that the dollar is going to decline and we are likely to see inflation in the intermediate and long term future (though I believe that prices will remain more or less stable for the next 6-12 months). My own approach to investing is one that favors simplicity. I learned a long time ago in the Navy that the more complicated you make something the less likely it is to perform well. We even had an acronym for this philosophy: KISS (keep it simple stupid). With this view in mind I try to limit my portfolio to around five or six positions, all funds, re-balancing at least semi annually and quarterly if needed.

With that view in mind I think one of the best hedges against uncertain future events, for those favoring a one stop fund for the conservative side of their portfolio, is the 5 star Permanent Portfolio Fund (PRPFX) . PRPFX maintains a rigidly fixed proportion of ultra-diversified asset classes which makes it highly resistant to market volatility. Its large holdings in bullion (20% gold + 5% silver) coupled with 10% in Swiss Franc bonds make this fund very attractive if you are among those of us worried about inflation. The fund also held up quite well during last year's crash and has one of the best track records among conservative allocation funds for the last decade.

For those favoring a less rigid approach one could compliment their bond portfolio with any one of a number of well run foreign (non-USD denominated) diversified bond funds. I like any of the Templeton Funds but they have a fairly steep minimum investment that might put them out of reach for the ordinary investor.

And it goes without saying that any well balanced portfolio will have some metals in it. Even during normal times I strongly believe at least 10% is in order. For metals I prefer gold over mining stocks. I favor GLD though an argument can be made for holding at least some physical bullion.

Disclosures: Long on PRPFX and GLD

May 07 05:56 PM

[Joseph L. S...:]

Thank you for your comments, sir. I have no illusion of infallibility, merely a willingness to review all the options and select those I feel are most worthwhile. I appreciate the reference to your article, which I just read. I think your emphasis upon TIPs and WIPs, precious metals, and traditional inflation beneficiaries, equities and REITs is well-placed for the inevitable inflation that will ultimately follow. I will use CEW et al short-term, but once the next deflation/recession scare has ended, our clients will be positioned for an ugly inflationary period!
Best Regards,
Joe


On May 07 05:13 PM Living4Dividends wrote:

> Excellent article ! I just wrote an article in a a similar vein on
> SA, titled "The Dollar Is Doomed" But - I came to different conclusions
> then you did about remedies for investors. I believe that no fiat
> currency is a safe haven - but the dollar is the least safest of
> the majors. Certainly if you want/need to hold currencies - it is
> better to be diversified into other currencies than the dollar.

May 07 06:29 PM

[Ponce:]

Buy silver and gold........but with silver being 80% more than gold, buy bricks of nickels and pennies beacuse in ten years they will be what silver coins are now.

Also.......save all your loose change because in the future they will retain its value as more paper fiat will be printed but not the coins.......as per Germany in 1923.

On the side?......water stock.......the oil of the future.

May 08 12:52 AM

[twitee:]

Hmmmm-Other currencies are doomed specially Euro and British Pound or Yen so there is no other save currency.......remember our sophisticated financial system flooded the world with bundled Mortgage loans at higher rates....most of it is in China and Japan, Europe does not even have a credit system or unity within the European Union. At least the FED Gang members are making quick delusional actions to fool the rest of the world, beside the FED controls the financial in Europe as well.

United States will remain the super power and even stronger in the future, because we still hold the brightest minds in the world. You cannot buy the intellect or create it out of thin air. The smartest people on earth have and will come to United States no matter what happens. Those people that have been traveling around the world know that there is no better place than US of A.

Buy Gold or Housing in United States, especially in California (the world brain center) are best the replacement for any other tangible asset.

May 08 05:41 PM

[Gold Barron:]

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property until their children wake-up home-less on the continent their fathers conquered."
–Thomas Jefferson

May 10 04:43 PM

[punk_ash:]

Joe,

You are not saying anything that many others are not. However, I have read few if any level headed and logical reasoning for the state of the affairs. I have lightened up on my equity holdings earlier in the week.

I do not buy ETNs, a friend of mine try to sell me one in 2006 when things were looking great, so I am sure I am not going to buy one now.

What are the risks involved in FXA and FXC or for that matter any foreign currency trust. I have limited understanding of the credit risks in these.

May 10 09:41 PM

[seelover:]

Quote of punk_ash:
We should all manage our own money, its not that hard anymore ..

Referring to your recent note could you please kindly elaborate the idea and possibly example a bit more for newcomer? (how to start, where to look, what to read and watch?, etc)
Thanks

May 13 05:23 AM