The TROUBLED U.S. DOLLAR

How to Profit from the Troubled Buck

Rationale #1: Growing pessimism about U.S. economic growth: The U.S. economy is decelerating much faster than U.S. policymakers care to admit. As we move into the New Year, I think the weaker housing market will lead a self-feeding weaker economy. It could push the U.S. into, or very close to, recession in 2007. And because of slowing growth and risk of recession, the next move by the U.S. Fed will likely be a cut in interest rates. The dollar will quickly lose its yield and growth appeal.

Rationale #2: Rising optimism about European growth: This represents the mirror image of the problems facing the dollar. Rising Euro-zone economic growth means the European Central Bank is likely to raise interest rates in 2007. I predict the euro will rally on yield and growth appeal.

Rationale #3: Central banks may move away from the U.S. dollar with the changing political face in Washington: As the U.S. dollar loses value, we will likely hear more noises from global central banks threatening to reallocate their reserves away from the U.S. dollar. Instead, they could start collecting euros and British pounds for their reserves. Also, with the power shift to the Democrats in Washington, we could see an increase in protectionist trade policy. Both these factors create a very negative sentiment backdrop for the dollar. It will likely embolden dollar bears.

It’s a triple whammy of trouble, based on solid rationales, lining up to hammer the dollar lower in 2007. The question is: How low can it go?

How Much Lower from Here?

To the right is a long-term chart of the U.S. dollar index. The all-time low in the index was 7819 back in 1992.

We’ve seen two major bear market phases in the dollar since 1971, when Nixon took the U.S. dollar off the gold standard and gave us a free-floating currency.

• 1971-1978: Seven-year bear market (President Nixon closes the gold window)—the U.S. dollar index fell approximately 31%.

• 1985-1992: Seven-year bear market (triggered by the Plaza Accord)—the U.S. dollar index fell 53%.

The current bear market for the dollar began in February 2002. That means this bear market is only 4.5 years old, or 2.5 years less than the two previous dollar bear markets. This bear has plenty of room to run further and deeper. We could easily see the old U.S. dollar index hit the all-time low during 2007, as the U.S. economy slows.

What Currencies to Keep in 2007

Japanese yen: We can blame the carry-trade for how weak the Japanese yen was in 2006. Right now, the yen is the most undervalued of all major currencies. But I expect the yen will rally hard against the U.S. dollar, and other major currencies, in 2007 when the carry-trade comes undone.

The fundamentals behind the Japanese economy are simply stronger than market players realize. The Japanese economy is normalizing. As Eric Roseman pointed out, bank lending is growing. Corporate profits are increasing. Capital expenses are expected to grow sharply. And the Japanese government is moving forward on structural reforms. Japan is also becoming increasingly integrated with China. And I expect China’s growth momentum to continue next year.

Besides the underlying economic fundamentals improving for Japan, there are two other reasons why I expect the yen carry-trade to unwind in 2007. First, I expect volatility to return to the market in 2007, after one of the least volatile years ever in 2006. Increased market volatility makes the carry-trade a riskier proposition.

And second, I expect the Bank of Japan to be more aggressive with their rate hikes in 2007. If that happens, the cost of the carry-trade will also rise. The yen could surprise everyone in 2007 if we see a violent end to the carry-trade. This happened once before in 1998. The yen carry-trade quickly unwound because the Asian Financial Crisis increased market risk. As a result, the yen rocketed 32%!

Euro: I expect the euro to hit a new all-time high against the buck in ‘07. The previous high was 1.3666 set back in December 2004. The euro should be powered higher because the European economy continues to surprise on the upside. Business confidence has returned and consumer confidence is improving.

The European Central Bank (ECB) will likely remain aggressive in hiking rates, given its strict inflation targets. I expect the ECB to hike benchmark rates once again early in 2007, taking rates up to 3.75%. I predict the euro will rally hard on a strong economy and rising interest rates. Or in other words, the euro will do the exact opposite of the U.S. dollar. And if the U.S. economy does head into a recession, the U.S. Fed will likely cut rates quickly. If that happens, short-term euro rates could cross above U.S. rates. That would give the euro a mighty boost.

In addition to growth and rates, I expect there will be more financial problems in the U.S. in 2007. And financial problems in the U.S. will lead to more central banks allocating their reserves away from the U.S. dollar and into euros. This could push the euro into overshoot territory in 2007.

British pound: The pound continues to be my favorite long-term play against the U.S. dollar. That’s because I expect the U.K. economy to continue to gain momentum and shock the markets. This will happen if the economy continues to benefit from strong international capital flow tied directly to its strong and vibrant service sector.

London has more foreign exchange trading and other international transactions than New York, Tokyo, and Frankfurt combined. This means the U.K. will be one of the prime beneficiaries of the ongoing transition from manufacturing to services in the global economy. The U.K. economy is better poised to leverage off the global economy than any other industrialized country.

I expect the BoE to raise rates sometime during the first quarter of 2007 to enhance the U.K.’s already attractive interest yield. Benchmark interest rates in the U.K. are poised to cross above those in the U.S. early in 2007. Just as the case for the euro, strong yield and economic growth will be powerful drivers for the pound in the months ahead. The pound is poised to test the US$2 level against the U.S. dollar. Many traders think the pound couldn’t possibly go as high as US$2. But remember the pound has traded as high as US$2.60 against the U.S. dollar in the past. If you consider that, US$2 per pound doesn’t sound so outrageous.

Swiss franc: The Swiss franc is lagging behind both the euro and British pound. Though I see it moving higher against the U.S. dollar next year, I believe it will continue to trade in the euro’s shadow. The Swiss franc has lost a bit of its shine as a safe haven currency. It’s no longer backed by gold, it has a relatively low yield, and it lacks appeal as a central bank deposit currency (those are currencies central banks want to keep in their reserves like the U.S. dollar, euro, and British pound). So I’m giving the Swiss franc third place for European bets, after the euro and pound.

Australian dollar: Of all the commodity dollars (Australian, New Zealand, Canadian dollar), the Australian dollar is my favorite for two primary reasons. First, the Australian economy is increasingly tied to the fortunes of China. And China should continue to be the major growth engine throughout 2007. And second, the Aussie sports the highest interest yield among the major currencies. The Aussie is extremely vulnerable to a pull-back in the commodity prices. But if global growth can continue at a reasonable level despite the slowing U.S. economy, then I expect commodities will still perform well in 2007. And that’s good news for the Aussie.

Canadian dollar: Recently the Canadian dollar has acted poorly compared to the rest of the major currencies. It seems the currency players have marked the Canadian dollar for a slowdown, because Canada’s growth is tied closely to the United States. Either the Canadian dollar could have a significant rally in 2007 because of Canada’s strong financial position and rising commodity prices, or it could decline as their exports decline when U.S. demand slows. So for now, I am neutral on the Canadian dollar in ‘07.

So,how can you profit? ! Study hard,earn lots on the way.

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