October 29, 2008

US dollar: Why is it going up

There could be a case to be made for higher inflation and a weak US dollar. The trade deficit and the enormous debt on the balance sheet of the US will lead to higher inflation and lower value of US financial assets. So the US dollar SHOULD slide, but markets have a mind of their own. This is more of a long term outlook once the economy has some legs under it.

What is obvious right now is the economy continues to slow and credit creation continues to contract, it's going to be very hard to get sustained inflation. I think prices are going to respond to the slower global economy. If that's true, then demand for commodities, demand for everything, goes down and some inflation subsides, as inflation is a lagging indicator and credit is a leading indicator. There's not a lot of credit being issued these days.

As for the US dollar, it generally appreciate when the global economy is slowing and in the time of financial uncertainty investor typically flock to US treasuries which means dollar appreciation. Moreover, leading central banks will pursue aggressive rate cuts, which only the US Fed was doing lately, to stimulate their economies. Lower rates abroad are positive for the US dollar.

You can certainly see this in the surge of the dollar lately. The dollar index surged 18% to 92 this month. For the week on the downside, the Brazilian real declined 9.8%, the Australian dollar 6.9%, the Norwegian krone 6.2%, the Swedish krona 6.1%, the Euro 5.7%, the Danish Krone 5.7%, the South Korean won 5.6%, the South African rand 4.8%, the Canadian dollar 4.5%, the Mexican peso 4.3%, and the British pound 3.9%. Examining this week's rout in some of the "emerging" currencies, the Iceland krona declined 16.3%, the Romanian leu 10.6%, the Hungarian forint 8.2%, the Czech koruna 7.3%, the Polish zloty 6.9%, the Turkish lira 6.3%, the South Korean won 5.6%, and the Chilean peso 5.4%.

The dollar have no legs to stand on; there is no fundamental reason for it to be higher. So I would not alter any investment strategy based on the recent trend. Some began to sell multinational corporation as they will hurt by higher US dollar. The rationale goes as those tail winds that elevated their earnings in the past will become head winds depressing their earnings.
The US election will not alter a weak dollar as both candidates are powerless to do anything about the deficit and government spending.

In my investment selection I will take advantage of this and pick those multinational, energy and metals as they will provide the greatest appreciation once the eventual decline in the dollar resumes.


DaveinHackensack said...

Have you considered an investment inversely linked to interest rates on Treasury bonds to take advantage of this, e.g., RRPIX?

Anonymous said...

As a Canadian investor, would you recommend hedging positions recently purchased in the U.S. market given the current exchange rate?

Sami said...

this product is a trading instrument more than an investment and it requires good timing to execute well. I do not have the skills to pull it off.

And due to the 125% relationship with the underlying your returns will fluctuate more than the underlying so even if you make the right call you might not realize any returns on the product.


I do. the best way to hedge is to buy US dollar short ETF with 1 to 1 relationship not the 200% exposure. However the problem with hedging is it cost you in opportunity cost on the funds committed to the ETF.

Anonymous said...

What particular US dollar short ETF do you favour and why not the 200% exposure? Also, for a $10K investment in the US market, what is the dollar amount and percentage point that you would hedge for this particular position?

Thanks for sharing your input.

Sami said...

because 200% products will give you twice the volatility but not twice the returns in the long run.

this is bit technical but a % move to the downside will not be offset by the same % move to the upside. this is what called geometric returns. and having 200% the move can magnify this relationship very quickly.

beside your objective is hedge not to gain.

if you go with etf you have to hedge dollar for dollar so you need 10000 to invest in an ETF. That why I said in my earlier comment that the opportunity cost can be significant as the 10000 can be put to use in another investment.

Another strategy is to buy a call option on an etf this way you need less capital.