How to Profit From the Rising Dollar

by: Cliff Wachtel

I notice that many readers are confused about why the dollar is rallying despite the numerous chronic fundamental weaknesses in the US economy. These include:

  • Continued job losses. Until recently, it appeared that at least the pace of these losses was slowing, but lately it has picked up again, casting doubt on the belief that the employment picture is turning around. That makes real recovery virtually impossible, because weak jobs and personal incomes in turn cripple recovery in:
    • Consumer spending, which comprises about 90% of US GDP.
    • The critical banking and housing sectors, which both depend om consumer spending and incomes for repayment of residential and commercial loans. Remember that these sectors led the US and the world into the current economic crisis, and are very likely to be key to a self-sustaining recovery.
    • Bank lending to small businesses, which are the typical job generator in a recession, remains depressed, limiting the ability of these businesses to hire and provide the solution to the very sectors that need them to produce jobs. US bank lending was down again in Q4 of 2009 by 7.5%. Small businesses tend to be last in line, suggesting the decrease for them was higher.
  • A growing state and municipal debt crisis as local taxes fall (from falling incomes and housing prices) and a growing load on social services.
  • Signs of weakening demand for US Treasury Bonds. At minimum, that suggests rising US borrowing costs. Of course, if the EU debt crisis continues to worsen (likely), US bonds could see good demand for lack of an alternative.

One could go on and on. So why is the US dollar rallying?

In short, because circumstances are making it rise in times of both fear AND optimism

I. Fear Factors Feed Demand For the USD As A Safe Haven

In sum: in forex, it’s all relative, and being least ugly is good enough to win. Just as the euro rose in 2009 simply due mostly to the market’s focus on the dollar’s troubles, so the dollar now benefits from focus on the EU’s troubles. It’s just a question of which economy seems to be in the most immediate danger.

Here are the key reasons why the US dollar remains among the least ugly.

The overwhelming reason is the EU sovereign debt crisis, which puts the euro in much worse shape.

  1. The threat of default is growing daily as time is running out for a long term plan that not only rescues Greece but the rest of the PIIGS block in a way that is neither too draconian for the debtors nor too lenient to attract support of the stronger EU countries that will foot the bill, and fear rewarding bad behavior will lead to more of the same. Currently there are no reported solutions.
  2. No EU Help: The PIIGS have so far lacked the will to accept the needed spending cuts, as austerity plans spark massive demonstrations and continued unrest. Similarly, Northern European leaders have shown no desire to commit political suicide by imposing additional burdens on struggling taxpayers to pay for Southern European mismanagement, tax-dodging, and corruption. Unless it receives aid, Greece could default within a month.
  3. No Demand For Greek, Portuguese Bonds: Last week Greece withdrew an attempt to sell bonds for lack of demand at affordable rates. Moody’s is considering a downgrade below an A rating, making Greek bonds ineligible for use as collateral in ECB borrowings. Portugal also had a failed bond sale this past month.
  4. Spain, Italy Present Bigger Threats: While Greece and Portugal may be first to default, they are not even the biggest threat to EU stability given their relatively small size. S&P stated Friday that:
  • “Spain’s general government deficit is likely to remain above 5% of GDP through to 2013 versus the official forecast of 3% of GDP by 2013. As a result, we expect the general government debt burden to rise above 80% of GDP by 2012. We also expect much weaker economic performance than current budgetary assumptions. There is, moreover, significant implementation risk with regard to the government’s fiscal consolidation plans, which are not yet fully specified.”
  • Others, including Nobel Prize winning Economist Dr. Robert Mundell, considered father of the euro, see Italy as the chief threat due to its having the largest absolute debt load (said to be up to 25% of the entire EU debt) and debt as a percentage of GDP similar to those previously mentioned.

The ramifications are chilling. The default of any of the PIIGS could well send borrowing rates for the others beyond affordable rates, effectively setting off a wave of defaults. Remember that the collapse of Lehman Brothers bank alone was enough to crash credit and asset markets in the fall of 2008. Imagine the panic caused by the collapse of Southern Europe.

That alone is enough to explain US dollar strength.

The EUR/USD pair accounts for about 33% of all FX trade, thus the two force each other in opposite directions like children on a seesaw. For every 3 euros sold, a dollar is bought.

As the #2 most preferred currency in times of fear, the US dollar benefits greatly from global “fear factors” like the EU debt mess. We haven’t even dealt with the ramifications of the threats of China growth slowing.

II. Relatively Good Underlying Economic Fundamentals

For all the fundamental problems of the US economy, it is still no worse than that of the UK, EU, and Japan.

The Fed is not considering further stimulus. The UK is openly discussing it, and the other two must be at least thinking about it. The EU needs to print money for any kind of rescue, and Japan has indicated it wants a lower yen, which as the #1 safe haven currency has also been rising in the current climate of EU induced fear.

Other advantages over one or more of the above include: It has one central government, has a better market for its bonds, a bigger domestic consumer base, and a more pro-business electorate. It also remains (surprise) the world’s largest manufacturer – higher output than all the BRICS combined.

Thus not only does the USD benefit as the #2 safe haven currency in times of fear, it also attracts demand for its relatively good underlying economic fundamentals. Again, the operative phrase here is ‘relatively good.'

The fear and fundamental factors feeding USD demand relative to the euro, pound, and yen matter a lot, because the EUR/USD, GBP/USD, and USD/JPY ALONE account for over half of all forex trade.

No banker or trader is going to get fired over keeping a strong long USD position at this time. What other choices are there for those needing to park cash?

The Dollar Could Benefit Regardless of What US Jobs Data This Week Shows

As suggested by the above, given the weakness of the dollar’s chief competition, the euro, the dollar stands to benefit no matter the result of US jobs reports.

If markets respond positively, it rises based on improved fundamentals of the underlying economy and rising expectations for stimulus reduction and rate increases.

If not, it is the #2 safe haven.

How To Profit

The key ideas to remember are that:

A rising USD pressures all other major currencies that trade against it, especially the #2 most liquid currency, the euro. It also pressures commodities, which are priced in dollars and thus become relatively cheaper.

Thus as long as the USD rallies:

  1. Long USD currency trades, and related assets like the ETFs: UUP, TLT.
  2. Short assets that benefit from the major higher risk currencies and commodities. These include
  3. Trading the actual currencies and commodities, stock market indexes or their CFDs (Contracts for Difference see The Coming Crude Oil Pullback: Using Contracts for Difference (CFDs) )
  5. Other plays along these themes using options, futures, etc.

DISCLOSURE: No positions