Many people think recent weakness in the U.S. dollar marks the beginning of a lengthy decline. With the global flight to safety waning, the natural tendency of a debased currency is coming to the fore. Indeed, net short selling of the U.S. dollar on the Chicago Mercantile Exchange during the week ending May 19 was the highest since the start of economic crisis.
This rising bearish sentiment is at odds with a suggestion I made several days agothat the U.S. dollar could rise as the fiscal deficit widens and pushes up interest rates. Perhaps I should explain some of the reasoning behind this statement.
While the huge government deficits planned for the next few years will put pressure on the Fed to print a great deal of money to buy government debt and contribute to further debasement of the currency, it will also put upward pressure on U.S. long-term interest rates. And this rise in interest rates will attract inflows of foreign capital that should put upward pressures on the U.S. dollar.
The precedent is the period from the early 1980s when President Reagan and Congress ran an enormous deficit that resulted in a flood of government treasuries being issued. Successively higher yields had to be offered in order to get investors to take up the Treasuries. Those higher interest rates attracted large inflows of foreign capital, which bid up the value of the U.S. dollar — until the Plaza Accord of 1985 reversed the uptrend.
At the moment, the currency market seems to be betting that the Fed will choose to finance a big chunk of the deficit by printing money rather than letting treasury yields rise. That might be a reasonable assumption this early in the recovery, which is still in the green shoots stage. Moreover, the Fed likely feels it can run the printing presses without trigging inflation as long as amount of slack in the economy is as huge as it is presently.
However, as the recovery becomes more firmly rooted, I believe the Fed will step back and let treasury yields rise, shifting more of the burden of deficit financing to domestic and foreign savings. In fact, this will be necessary to cut the risk of igniting galloping inflation. In any event, rising bond yields should draw in foreign capital and boost the U.S. dollar.
If this scenario is the one that unfolds, it may be worthwhile over the next few months to pick up some units incurrency ETFson any further dips in the U.S. dollar. Canadian investors not fearful of double-leveraged ETFs could consider the Horizons BetaPro U.S. Dollar Bull Plus ETF ( HDU). In the U.S., there are a lot of choices, including PowerShares DB US Dollar Index Bullish Fund ( UUP).
It also seems worthwhile to continue holding the inverse bond ETFs suggested in the April 22 post, such as theProShares Ultra-Short 20+ year Treasury ( TBT). One ETF I didnt mention, but perhaps could have for Canadian investors, is the Horizons BetaPro U.S. 30-year Bear Plus ETF ( HTD). The ETFs are up 10% to 20% since the post appeared. They might suffer a setback near term if the Fed moves to buy down treasury yields, but I would see such a reversal asmore as a chance to add to (or start) positions.