The Dollar’s Rise is Temporary

January 20, 2009 · Posted in Weekly Posts

The dollar has been on a roll lately today making significant gains against the Euro and every major currency except the Yen. Many will argue that this reaffirms the strength of the US dollar as the reserve currency of the world and proves that in a severe economic crisis, such as we are experiencing, the world still turns to the US. As readers may expect, Murdock Global Insight takes a somewhat different view.

To begin, let’s look at what else is happening in the world today. Russia is devaluing their currency at an increasing rate. Anyone in Russia who has money at all, the rich (or formerly rich) and the middle class are all converting roubles into dollars. This is a full blown currency crisis – the locals are selling. European banks are having a hard time. Ireland has nationalized it’s third largest bank and the Irish PM is denying that they will need an IMF bailout. We all know that denials of needing the IMF usually result in an IMF bailout. Greece has had it’s debt downgraded. Other small nations are on credit watch. So for the Euro zone and surrounding countries the message is – the banks are in trouble, our credit is suspect – get out. The Euro is a very new currency. All of the citizens of Euro zone countries who are in the market grew up with national currencies. When the national currency got into trouble in the past where did they go? To the US dollar. So where do they go now? To the US dollar. Is it because the US fiscal house is so well maintained? Is it because our economy is roaring? Is it because we have a new president? No, it is because it is not the Euro or rouble or their local currency and it’s big and liquid and they remember it being sound. The average person selling does not have a deep understanding of the current state of the US economy.

What do we know about how these dollars are being deployed? Our equity markets are going down. The US treasury market went down today. So they are not buying stocks nor are they buying government bonds. What did go up today was gold and oil. All other major commodities were down. Looked at in this light it appears then that the recent rise in the US dollar is a hot money flight from the Euro zone and Russia to something large and liquid. It is not a vote of confidence in our economy as no investment flow is apparent into our bond or stock market. It is hot money and it will come right back out of dollars when the immediate need to “flee” has subsided. The recent rise of gold in the face of a rising dollar is completely consistent with this.

We also need to consider the possibility that hedge funds are repatriating funds in preparation for further redemptions. This would obviously not be considered a positive for the dollar or the economy but merely an artifact of the continued declines in global equity markets. Finally, a rising dollar coupled with declining global equity markets causes US based international mutual funds to take heavy hits. We are undoubtedly seeing some repatriation of funds here as well.

None of the above trends are long term trends and none of them say anything much positive about the longer term health of the dollar. We feel once these short term trends complete, the dollar will again be driven by the health, or lack thereof of the US economy, and the size of the US debt and deficit. As outlined in our Members Only Post “The Coming Bond Debacle”, the US fiscal situation is almost certain to cause a severe drop in the dollar going forward. Consequently we remain short the US dollar index through UDN, long the Australian dollar through FXA, and are cautiously shorting the Treasury market through PST*. We will articulate our emerging views on Gold later this week.

*Note to readers: PST is a leveraged short ETF. There is considerable controversy regarding the use of these investment vehicles due to their volatility and effect on the markets. Readers seeking to invest with such an ETF should thoroughly investigate the pros and cons and the suitability for their portfolios prior to committing funds.