Dollar Myths

By: Axel Merk | Thu, Apr 26, 2007
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Without shying away from controversy, we do away with a number of myths of why the dollar ought to move up or down.

Myth I: The dollar is safe because the U.S. has ample assets

Some say the current account deficit that requires foreigners to arrange for over $3 billion of capital inflows every business day just to keep the dollar from falling does not matter. These pundits say a deficit of 6.5% of Gross Domestic Product (GDP) is sustainable because the deficit is only about 1% of all private assets held in the U.S.; as a result, deficits could be carried a long, long time.

This argument is one about the dollar going to zero, an extreme case of the dollar losing relative to other currencies. However, the current account deficit and its affect on the dollar is about cash flow: by putting it in the context of a GDP is reasonable, as GDP is a cash flow measure of production. Comparing it to private savings is mixing apples with oranges.

Myth II: The dollar is doomed because of our large budget deficit

Just as dollar optimists are wrong to say the dollar is safe because of our tremendous wealth, dollar pessimists are mistaken to put too much emphasis on the budget deficit. By issuing debt, the direct impact of the budget deficit can be mitigated to the burden of interest payments. Of course, as interest payments become excessively large, they will weigh on the dollar eventually. However, the linkage to the dollar is indirect. While it is correct that large budget deficits structurally weaken the U.S. in the long run, it is not appropriate to link short-term dollar movements to the budget deficit.

Myth III: A lower dollar will cure the trade deficit

All too often we hear how much more competitive we would be if we only allowed the dollar to fall. While a weaker dollar may be a short-term boost to earnings and make exports a tad more competitive, it will not bring back industries that have been outsourced. It is most unlikely that the U.S. will thrive on exporting sneakers to China, no matter how low the dollar will fall.

What a weaker dollar may do is provide temporary relief. But unless the U.S. turns into a society of savers and investors, a weaker dollar will only be a pause to an even weaker dollar as imbalances are built up yet again.

Myth IV: A lower trade deficit will save the dollar

Odds are that the current account deficit may be close to its peak. However, that does not mean the dollar is out of the woods: if an abatement in the rate at which the current account deficit deepens were due to a sustained improvement in savings and investments, it may have long term positive implications for the dollar. But it looks like the driver behind any 'improvement' (if one can talk of such as the deficit continues to widen) will be due to a drop in domestic consumption due to a slowing economy. Rather than being good news for the dollar, this discourages foreign investors to invest in the U.S. American CEOs focus their investments abroad, so why should foreigners invest in the U.S.?

As the economy slows and consumers can no longer extract equity from their homes, the savings rate ought to go up. Famous for having dipped into negative territory, consumers have to pare back their spending as access to easy money dries up.

Myth V: A weak economy causes a currency to falter

We agree that the U.S. economy is heavily dependent on growth to keep the dollar stable. But it is a U.S. specific problem: in the current environment, it may not apply to the European Union. The key difference is that, in recent years, the European Union has focused on structural reform rather than growth; as a result, it does not have the severe current account deficit the U.S. has. Should the world economy slow down, many markets may suffer, but the euro might still do comparatively well. Europe has plenty of issues, but as far as the euro is concerned, the region is in a very strong position.

In contrast, a reduction of foreign money inflows into the U.S. is the single biggest threat to the greenback. As a result, the dollar has been reacting negatively to any news signaling a slowdown of U.S. consumer spending. And as consumer spending is closely linked to the fate of the housing market, negative data on housing may reflect negatively on the dollar. As the housing market is not very liquid, any adjustment process is likely to be long and grinding.

Myth VI: China is the problem

In our assessment, China is the most responsible player in Asia. Unlike China, we believe other Asian countries, including Japan, are willing to risk a destruction of their currencies in order to continue to export to American consumers. The Chinese are taking their imbalances very seriously and are working hard at addressing many issues facing a nation governing 1.4 billion people. Having invited Western investment banks to invest billions in their local banks has provided an encouragement for reform from within.

If there is one thing that spooks the currency markets more than a slowdown in U.S. real estate, it is the flaring up of protectionist talking Congress. When presidential candidate Hillary Clinton recently expressed concern about the Chinese buying up the majority of U.S. debt, the dollar fell sharply. If protectionist measures increase, foreigners will have fewer incentives to purchase U.S. dollar denominated assets, providing pressure on both the dollar and interest rates.

Interestingly, nobody seemed to focus on the fact that there is an unconventional solution to foreigners holding too much of our debt: live within your means and do not issue debt. Such an old fashioned concept would indeed strengthen the dollar. Unfortunately, none of the presidential candidates at either side of the aisle seem to have heard of this notion.

Myth VII: Higher interest rates help the dollar

It seems that ever since academics developed a theory of how interest rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus in on interest rates. Why do some low yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?

A good year ago, the U.S. joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher U.S. interest rates mean higher payments abroad, further weakening the foundations of the U.S. dollar.

There are many more myths about the dollar, but the selection above may provide some food for thought. Investors interested in taking some chips off the table to prepare for potential turbulence in the financial markets may want to evaluate whether gold or a basket of hard currencies are suitable ways to add diversification to their portfolios. We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.

 


 

Axel Merk

Author: Axel Merk

Axel Merk
President and CIO of Merk Investments, Manager of the Merk Funds,
www.merkfunds.com

Axel Merk

Axel Merk wrote the book on Sustainable Wealth; peek inside or order your copy today.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Merk Investments LLC makes no representation regarding the advisability of investing in the products herein. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice and is not intended as an endorsement of any specific investment. The information contained herein is general in nature and is provided solely for educational and informational purposes. The information provided does not constitute legal, financial or tax advice. You should obtain advice specific to your circumstances from your own legal, financial and tax advisors. As with any investment, past performance is no guarantee of future performance.

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