Why You Shouldn't Speculate on the Dollar

|
Includes: ADE, CUD, EEM, ERE, FXA, FXB, FXC, FXE, FXF, FXY, JYN, SPY, SZE, TIP, UDN, UUP, VNQ, WIP
by: Living4Dividends

The dollar bears are having a field day with the fall of the dollar. I'm also a dollar bear, having written articles with such titles as: The Dollar Is Doomed and Will The U.S. Dollar Crash?

It Ain't Easy Being a Dollar Bear

Over the past century (1900-2000), the dollar has kept its value far better than fourteen of the fifteen hard currencies of the world. The dollar has been stronger than the German mark, Japanese yen, British pound sterling, Australian dollar (formerly pound), French franc, and other hard currencies. The dollar has held its value better than any other major currency except for the Swiss franc. {Source: "Triumph of The Optimists}

Blame it on the War

World War II caused the decline of the European currencies and the dollar's rise to preeminence. So, let us disregard the war-torn first half of the century, and focus on the second half. From 1950-2000 the dollar has kept its value better than ten out of fifteen of the leading hard currencies of the world. During this period, the US dollar was bested only by the German mark, Japanese yen, Belgian franc, Danish krona, the Dutch guilder and as always; the Swiss franc.{Source: "Triumph of The Optimists.}

No Currency Is a Safe Haven

In a recent article on Seeking Alpha, author Jonathan Bernstein does a terrific job of documenting the dollar's weakness:

Of course the market knows about America’s troubles and some of them are priced in. Currency traders would also remind me that currencies are priced relatively to each other: we speak of yen per dollar, or dollars per euro. So if you are bearish on the dollar you can’t just prove that the dollar is weak. You need to show why it is weaker than the alternatives as well.

Before doing that I will concede the obvious: other countries also have troubles. We are in a recession, and so is just about everyone else. Our Federal Reserve is printing ridiculous amounts of money, but other central banks are too. Our government runs a large fiscal deficit, but again, other countries do too. Our banking system is weak, but the Brits and the Eurozone have nothing to write home about here either.

As a strong currency, the dollar has had a good track record. Nowadays the dollar is fundamentally weak. Other currencies are weak as well, but less weak than the dollar. This does not make other currencies safe havens. A slightly less weaker currency is STILL a weak currency. Even though the dollar will fall: other currencies will also fall in real value. Therefore, as myself and others have said previously: no currency is a safe haven.

One Day, the Music Will Stop

By importing more than we export, the US has built up one of the world's largest current account deficits. Normally this trade imbalance would make the dollar decline in value until the trade imbalance is zeroed out. Foreign central banks, however, have intervened to keep the dollar strong by reluctantly buying massive amounts of dollar-denominated bonds. Every year, foreign central banks buy more Treasuries, adding to their growing pile of dollar-denominated IOUs. The result is the US has the largest outstanding debt owed to foreigners.

The dollar's position as the world's leading reserve currency is both a blessing and a curse. The blessing is: we get to borrow massive amounts of credit at low interest rates. The curse is: when the rest of the world decides to divest itself of the dollar, the results could be catastrophic. The risk of being the number one reserve currency is unique to the dollar. Eventually, the music will stop playing and foreigners will decide to stop buying dollars and get rid of their massive dollar holdings.

Fortunately reserve currencies do not die overnight. As the fall of the pound sterling demonstrated in the last century, the decline of a reserve currency takes decades. The dollar is fundamentally weak and due for a fall, but the decline could take decades.

Why You Shouldn't Speculate Against the Dollar

Fund companies have created ETFs that allow you to bet on the direction of the dollar. One such ETF is PowerShares' DB U.S. Dollar Bearish Fund (NYSEARCA:UDN). UDN uses options that bet on a decline in the dollar.

Over years or decades, as the dollar declines, UDN's strategy could be profitable in theory. As the above chart shows, the dollar has declined slowly over the last three decades, a time-span well beyond the scope of most futures. As well, three decades worth of UDN's fund expenses and internal commissions would eat up most of the profits from the decline in the dollar.

As the above chart shows, the decline of the dollar will be extremely bumpy. Along the way, some crisis will cause the dollar to rally, decimating the value of dollar bearish futures. Even though the dollar is fundamentally weak, investors place speculative bets against the dollar using options should heed the investing maxim:

The markets can stay irrational longer than I can stay solvent.

Instead of Betting, Diversify Your Risks

Buying currency options is like placing all your valuables in one house without insurance while simultaneously placing a bet that among the ten houses in your neighborhood, one will burn down.

Buying insurance is mandatory for houses, but expensive for equity investments. To reduce catastrophic risk, a lower cost method is to spread your valuables among many houses. By diversifying your risk you avoid a catastrophic loss of wealth.

Solutions for the Prudent Investor

Since we can't rely on the dollar to maintain its value, it is imprudent to store all of our wealth in dollars. Hedge against a dollar decline without using expensive, complicated options.

  1. Protect against dollar devaluation by diversifying a heavily dollar-denominated portfolio using foreign bonds.
  2. Protect against global inflation using US and Foreign TIPs.

Full Disclosure: Author is long US and Foreign TIPs (NYSEARCA:WIP). You should consult with a professional investment advisor before investing.