Watching the USD Drop? Here's What You Should Really Be Watching

Includes: UDN, UUP, YCS
by: Shishir Nigam

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The USD vs the JPY is weakest in years. Yes, the DXY dollar index has been hitting new lows around 74. Yes, US government debt and deficits (the 2 infamous “D”s) have been skyrocketing and are projected to keep on growing in the coming years. Yes, the printing presses started by Ben Bernanke might be running faster than most people are comfortable with. And yes, the coming inflation will lead to further devaluation of the dollar which the government will not attempt to stop because they are happy to inflate away their piles of debt.

We’ve all heard the reasons for the demise of the US dollar. But here’s the bigger picture. The USD does not exist in isolation in the forex markets. Every USD exchange rate that is quoted is RELATIVE to other currencies. The US dollar will depreciate relative to other currencies in the long term, if and only if, fundamental conditions in the US are RELATIVELY MORE worse than in other major economies. And probably the most important currency cross to RE-consider is the USD-JPY, which has recently touched 10-year lows.

Worried about the US debt burden are you? There is enough reason to be – the debt-to-GDP ratio is projected to rise from 65% to 80%.

The ageing population in the US is going to stress the social welfare programs which will cause deficits to rise even further. But you just might be worrying about the wrong deficit.

Here’s a reference point – Japan’s debt-to-GDP ratio at the end of 2008 was 173% (trumped only by Zimbabwe at 241%) and is forecasted by the IMF to rise to 200% by 2010. Japan’s population structure is now so lopsided that its death rate per 1000 people exceeds its birth rate (despite having one of the world’s highest life expectancies), and Japan hardly benefits from the growing young immigrant populations that the US enjoys. As a result, Japan’s population has been declining since 2007. Let’s talk about social welfare. The US has fewer and fewer people in its workforce that are available to support the growing pool of retired citizens. In 2009, this ratio stood at around 4.5 working age citizens for every person above 65.

In Japan, this ratio stands at 2.5. While the US economy derives about 70% of its GDP from its consumers, the Japanese economy is much more export driven and hence much more dependent on global demand. With the kind of conditions and start-stop recovery forecasted globally, Japan has a lot more to lose than the US.

And finally, one of the biggest arguments against the USD is countries diversifying their reserves away from US Treasuries. Contrary to popular belief, China does not OWN the US. In May 09, the US owed China (the biggest foreign holder) $772 billion which is only about 6% of the roughly $12.9 trillion in total national debt. Any attempts to diversify could just be a ripple in the ocean, a ripple that might just hurt the lenders more than the debtor.

All that to say, with the USD/JPY cross standing near 10-year lows, we could be staring at a huge opportunity, only to watch it go by. How could you translate this into a strategy? Go short JPY, long USD.

Or more directly, go short Japanese Government Bonds (JGBs). Remember that this is a view for the medium-to-long term, as traditional moves to the “safety” of the USD might persist in the near-term. UUP (US Dollar Bull) filed to issue 100 million new shares to meet rising investor demand – if that’s any indication, the tide may already be turning.

Disclosure: Author is long US stocks, no exposure to JPY.

Image credit: velo_city under a Creative Commons license