The future of the US dollar û and how to protect yourself

Remember: on October 25, 2000 the euro/dollar rate was below 0.83. On November 17, 2004 it breached the 1.30 barrier. Asian currencies have been less affected by the dollar weakness, nevertheless the yen gained almost 20% and the Korean won 25% against the dollar between their troughs at the beginning of 2002 and today. Back in the year 2000 it would have been a rare market participant who did not believe the US dollar was the king of currencies. The euro, meanwhile, was the currency of a central bank whose governor made statements as wild as his hairstyle. The dollar, by contrast, was looked after by a central bank presided over by a man who also made (and still makes) mysterious pronouncements but who enjoyed (and still largely enjoys) the cult status of a profound connoisseur, a 'maestro' of all things economic. Productivity and the New Economy were the be-all and end-all back in 2000, and among other things they determined how currencies were valued.

Since then, of course, prevailing opinion has swung full circle. Productivity, still the driving force behind US economic growth, is no longer of interest to investors. Attention is now focused squarely on the immensity of the current account deficit, which has swollen to almost $600 billion or 6% of US GDP.

Dollar weak in the short to medium term
Why this change of heart? If we look at the current account deficit in isolation, there are at least three reasons why this has now become a problem for the US dollar. Firstly, the deficit has swollen considerably over the past three years. A shortfall of $350 billion was more or less bearable for the world economy, whereas $600 billion is certainly not. Both in real terms and relative to GDP, it is currently nearly twice as large as it was at the end of the Reagan era in the late 1980s. Secondly, the cause of the current account deficit has changed. In the year 2000 it was US firms that were taking on debt by relying on foreign capital to fund their investment activities. Back then, the US government had a huge budget surplus. In the interim, however, it has built up a budget shortfall of between $300 and $400 billion, thereby becoming the driving force behind the nation's current account deficit. Thirdly, the current account deficit is being financed less and less by foreign private investors keen to buy US stocks and therefore fuelling demand for the dollar. Instead, it is being funded more and more by foreign (mainly Asian) central banks buying US treasury bills in a bid to prevent their own currencies from appreciating too vigorously. Each of these three reasons on its own would be reason enough to drag the dollar lower. Together, they represent a mighty burden on the US currency.

Soft dollar no solution on its own
So the dollar is falling. Will that solve America's current account problems? According to the average 'Introduction to Economics' textbook, the answer is a resounding "yes". After all, a weaker currency means that exports rise and imports fall, causing the trade deficit (in the case of the US, almost identical with the current account deficit) to contract. In reality, though, things are not quite so straightforward. The US has bilateral trade deficits with many different countries and currency zones. If the dollar is weaker against the euro, the bilateral US trade deficit with the euro zone (accounting for around one quarter of the total deficit) will probably shrink. But it is doubtful whether a weakening of the dollar against the yuan would have any impact on the US's bilateral trade deficit with China. Many Chinese exports to the US are goods on which Americans rely because they are no longer made in the US. It therefore requires more than just a weak dollar to solve the country's current account problems.

Above all, Americans must start saving more again. To this end, the US government must cut its budget deficits, and private households will have to rein in their consumer spending. Naturally, neither of these demand-side developments will do much for growth. Bringing the US current account deficit back down to more manageable proportions will therefore entail not only a weaker dollar but also weaker US economic growth and, to the extent that the rest of the world depends on its exports to the US, weaker growth in the global economy.

Despite the fact that a weaker dollar will not solve all the US-deficit issue, the hottest question among currency dealers today is whether and if yes, when and how the Chinese will realign their currency peg to the US-dollar. The answers to this question are as multiple as the currency traders ranging from "next week" to almost "never ever" and showing that there is no simple scenario. Rather than trying to focus on this issue and to deliver still another – most likely wrong – answer, let us instead look at how to protect yourself from further dollar depreciation.

Only consciously take currency risks
First of all the basic rule for every internationally-exposed investor should be: "never take a currency risk that you are not aware of". This means that every currency exposure due to other asset class exposures (e.g. foreign equities or bonds) should be either explicitly acknowledged for and therefore the risk should be consciously taken or it should be hedged. Of course hedging via forwards, options or other structured products costs something (the costs being equal to the interest difference between the two currencies) but most of the analysis and studies relating to this subject are showing that the out-performance and/or the risk reduction of hedged portfolios against unhedged ones more than compensate for these costs.

Alternatively to hedge dollar positions against a too large depreciation with regard to the home currency could be achieved via assets that are known as dollar hedges, like commodities and especially gold. Gold had a negative correlation of -0.85 with the euro/$, over the past six years meaning that whenever the dollar went down against the euro, gold went up against the dollar. The correlation with the yen is less evident with only -0.4 but it reaches -0.6 in the case of the nominal trade-weighted dollar. Of course investing in commodities means that instead of taking the dollar currency risk you take risks inherent to this specific asset class. This should be carefully analyzed before doing it.

One can also think about actively investing in other non-dollar currencies. The yen will most likely appreciate against the dollar in case of a Chinese realignment. Other Asian currencies will also. So if you are, for example, a Malaysian ringgit based investor you might hedge your dollar positions by investing more into other Asian countries. For the euro and by extension for other European currencies the situation is less clear. On the one hand the fact that people might chose alternatives to the dollar will most certainly attract investors in the euro, on the other hand, as the euro has taken the bulk of the dollar depreciation until now it might soften against the greenback, as international investors become more eager to spread their dollar risks among other (especially Asian) currencies.

Ultimately, the private investor's relationship with the dollar depends on his or her investment horizon. Over the short to medium term, it is advisable to underweight this unit. Over the longer term, however, and in spite of the US's current huge deficit problems, it might not necessarily be wise to do without the dollar. Back in 1995 there were similar mutterings about the end of the dollar era. Then the greenback had dipped below 1.40 against the deutschmark and below 85 against the yen. Just three to five years later the dollar was alive and well, having gained more than 60% against both currencies. And, as everyone knows, history often has a tendency to repeat itself.