US Dollar Myths

By: Axel_Merk

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 .

By Axel Merk
Axel Merk is Manager of the Merk Hard Currency Fund

© 2007 Merk Investments® LLC
The Merk Hard Currency Fund is managed by Merk Investments, an investment advisory firm that invests with discipline and long-term focus while adapting to changing environments.
Axel Merk, president of Merk Investments, makes all investment decisions for the Merk Hard Currency Fund. Mr. Merk founded Merk Investments AG in Switzerland in 1994; in 2001, he relocated the business to the US where all investment advisory activities are conducted by Merk Investments LLC, a SEC-registered investment adviser.

Mr. Merk holds a BA in Economics ( magna ***** laude ) and MSc in Computer Science from Brown University, Rhode Island. Mr. Merk has extensive experience and expertise in how the global financial imbalances, as evidenced by an enormous trade deficit, affect the markets. He has published many articles describing complex economic phenomena in understandable terms and he is a sought after expert presenter and moderator at conferences. Mr. Merk is a regular guest on CNBC, and frequently quoted in Barron's, the Wall Street Journal, Financial Times, and other financial publications.

In addition to 20 years of practical investment experience, Mr. Merk has a strong foundation in both economic analysis and computer modeling. His research in the early 1990s focused on the use of computer-aided models in financial decision making; he is a published author in “Adaptive Intelligent Systems” * and has been awarded a prize for excellence in economics. **

Mr. Merk focused on fundamental analysis of US technology firms in the early to mid 1990s, he diversified to other industries to manage volatility in his investments. In the second half of the 1990s, Mr. Merk received an early warning of the building bubble when he recognized that more and more companies were trading in tandem, causing the diversification offered through investing in other industries to diminish. As a result, he broadened his investments internationally. As the bubble burst and Greenspan and the Administration preserved US consumer spending through record low interest rates and tax cuts, imbalances in the global financial markets reached levels that Mr. Merk deemed unsustainable. Merk Investments has since pursued a macro-economic approach to investing, with substantial gold and hard currency exposure.

Merk Investments is making the Merk Hard Currency Fund available to retail investors to allow them to diversify their portfolios and, through the fund, invest in a basket of hard currencies.

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