May 13, 2011

Currencies & Strategy: A Tale of Two Forecasts

There are competing views on which way the U.S. dollar, the euro and other currencies will move

Currency confusion has reached epic proportions. At the inception of the credit crisis, a pattern emerged in which the dollar would plunge until European sovereign-debt worries triggered a flight to safety and a dollar rally. As Europe and the IMF restored stability, the dollar plunged again and the process repeated.

Erik Swarts captures this patternin his Market Anthropology blog. What’s most striking in the blog is the symmetry of the chart — namely, the inverse relationship the two currencies have exhibited since the late summer of 2007. The euro has the upper hand right now, but Swarts implies that this may not last long.

“Europe holds the majority of debt from the commodity rich emergent markets that were in free fall, due to the collapse in the CRB Index in 2008…,” Swarts explains. “If and when the commodity sector actually breaks down for the cycle, Europe will not only have to deal with their respective sovereign debt issues, but the sleeping minefield of subprimesque loans to those emerging markets so heavily dependent upon bubblicious commodity prices.”

For good measure, he adds,“the ECB still has to deal with the 12 disparate growth and debt tracks” and “a sovereign wealth crisis every other month.”

Should investors prepare for a new flight to safety by scooping up dollar assets?

Not according to Axel Merk, chief investment officer of Merk Investments. “Imagine a country that spends and prints trillions to patch up any problem,” explains Merk, in an article published Thursday in the Financial Times, entitled, as if in answer to Swarts, “Dollar in Graver Danger than the Euro.”

“Now imagine another country where there is no central Treasury, meaning that bail-outs are less easy, and which has a central bank that has mopped up liquidity over the past year, rather than engage in quantitative easing. Why does it surprise anyone that the latter, the eurozone, has a stronger currency than the former, the U.S.?”

Merk suggests that sovereign debt problems relate to crisis in “peripheral” countries and are reflected primarily in bond spreads, not the euro itself.

So who’s right? Which economy and currency exhibits greater rot?

In my opinion, Swarts is correct that Europe has lots of issues to confront, but lacks effective policy tools to get the job done. But while the Fed has the tools, the U.S. lacks (as yet) the political consensus necessary to prevent a fiscal train wreck.

Our economic train is big, and it takes a long time to slow it down. Will we really be able to do so before a chain of insolvencies in states, cities or entitlement programs begin? The U.S. is a country where, after all, government-funded lifeguards are earning more than $200,000 a year.

I can quibble with Merk also. The debt of those peripheral countries will ineluctably be transferred to Europe’s wealthy core, which will no longer be as wealthy. And while he minimizes in his article concern for those peripheral countries, I would tend to maximize concern, especially as relates to Spain.

Economic confidencein Europe is low, housing prices are spiraling downward and personal debt levels are astronomically high, a formula for a tsunami of bank failures with just a bit more stress added to the mix. With political unrest in Arab lands driving up oil prices, it wouldn’t take much to cast Spain and the other PIGS over the edge —  another European Central Bank rate hikecould do the trick.

So which side of the trade should you take? It is not clear to me, and that’s really my point. Two smart analysts make the opposite argument on the same day, each having mustered compelling evidence.

Forex is not for the faint of heart. The best approach is to maintain a globally diversified equities portfolio along with a healthy mix of hard assets, such as commodities and real estate.

Investment is a vote for hope; the other asset classes a vote for realism. Saving and investing is something we can do; predicting the future is something no one can do.

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