Currency Capitalist – November 2008
This Month:
Panic Trumps Fundamentals
Dollar Embarks on Short-Term Rally Plus Expect More Pain for the Pound and Icelandic Krona to Come
By Chuck Butler, Editor
The financial sector has definitely changed since I penned the last issue of Currency Capitalist. I’m going to take a little creative license and deviate from my usual focus on just how currencies are performing around the world.
Instead, I want to dive into the current financial meltdown and do some explaining. Along the way, I’m also going to give you an update on all the currencies I have my eye on including the longsuffering pound, the star-studded Nordic currencies, and the now bankrupt Icelandic krona. Plus, I will give you my take on the most surprising rally of the year — the greenback.
For years I’ve explained how “underlying fundamentals” drive currency values. And, for the most part, fundamentals continue to affect currencies even today. However, something else is happening here right before our eyes that is pushing fundamentals to the rear.
We’re officially entering uncharted waters here, as a very different trading theme emerges in the global market place.
Let me go on record as saying: Trends are NOT One-Way streets. You should always expect volatility within a trend – especially a dollar trend. This means just because we’re currently in a weak dollar trend doesn’t mean we can’t see a dollar bounce. In fact, it happened in 2005. We saw dollar strength in 2005, while remaining in the weak dollar trend.
First let’s review the awful “underlying fundamentals” that have kept the dollar in a weak trend since 2002. First of all, the U.S. has four Deficits…the Budget Deficit, National Deficit, (that includes both the Trade Deficit and Current Account Deficit), the Savings Deficit, and the Leadership Deficit. We’re finding out that “deficits do matter.”
I tell people all the time that anyone who says that “deficits don’t matter” should know better. Deficits always remind me of a guy standing on top of the Empire State Building. He decides to jump off and as he falls past the 56th floor, he says, “So far, so good!”
It’s the same for our deficits. So far, everything is “so good” for our debt-ridden economy. The “deficits don’t matter” crowd can easily ignore the deficits because the chickens haven’t come home to roost just yet. But they will. We all know they will, especially when we begin to see the Baby Boomers drawing on their entitlement programs!
In addition to the big four deficits, we have to attract foreign investment to finance those deficits. We have to draw funds from around the world to the tune of over US$2 billion per day. How long can we depend on the kindness of strangers?
Add to those, the fact that interest rates remain very low, and are very likely to be heading lower, rising unemployment, and a major loss of purchasing power.
All of these have caused a weak dollar trend, and all of these will come to the top once again to cause further weakness in the dollar. But first…
First, we have a trading theme that’s playing out that has pushed the underlying fundaments to the back of the classroom. And it’s creating a very interesting opportunity…
Dollar Fundamentals Take a Backseat to Panic
Welcome to the uncharted waters.
The financial sector has really taken a turn for the worse. They are circling the bowl. At no time in the past, did anyone, not even a sort of gloom and doom guy like me, think things could get so bad. Yes, I thought there would be pain and a recession. But then, I honestly believed we would all come out on the other side in one piece. However, right now, it looks as though we may not even have the pieces when, or even if, we come out on the other side.
The same U.S. investors who enjoyed huge profits overseas for the past six years are panicking. They’re dumping their overseas investments as fast as they possibly can, and bringing their dollars back home. This is called “repatriation.’
That’s right! In the deepest, darkest days in Japan’s economy, the Japanese yen managed to rally. And it was all because of Japanese investors. For years before this crisis hit, Japanese investors added to their already deep pockets and then invested overseas. But once the crisis hit, these wealthy investors grabbed their yen from overseas markets and brought it back home in case things got any worse.
Japan had never really left the deflationary period of the 90’s until recently. But the Japanese economy did see a bit of light in their capital markets at the turn of the century. When that happened, the yen weakened once again. The Japanese economy’s underlying fundamentals had finally come back to the front of the class, and the yen paid for it.
Doesn’t Japan’s plight sound familiar? The stimulus packages, the low interest rates, etc. all sound like what’s going on here in the United States. A former colleague of mine, Chris Lissner, and I sat down in 2002. We began tracking the charts of Japanese yield curves, recessions, etc. and comparing them to the same data in the United States. Guess what? We discovered they all looked very similar.
So here we are! The U.S. is choking on greed and corruption, and the dollar is rallying, just like the Japanese yen did in the mid 90’s. So the opportunity here is that when the deep dark clouds settle over the U.S., you buy the dollar. Then when the skies clear, you sell the dollar.
Sounds simple enough. But of course, the question is “how long, can this all continue?” Well, unfortunately, those are the uncharted waters I speak of. But think of it like this… The darker things get in the U.S. the better it will be for the dollar. I would look for this to go on for at least six months.
But all is not lost! Just because the dollar is strong does not mean we put away our currency trading clothes for the winter! After all, this will most likely be a short-term phenomenon for the dollar, so why not take advantage of this dollar strength?
There are so many such currency vehicles that will allow you to take advantage of this significant trading theme. My colleague Kat will tell you about one of the best vehicles you can use to cash in on this short-term dollar strength. Look for her complete coverage on this opportunity starting on page 7.
When the Time is Right, Use This Short-Term Rally To Buy Foreign Currencies
When the dollar is falling, it seems like everyone wants to jump on the Forex bandwagon.
In fact, last year, investors poured into the currency markets as news sources around the world were printing headlines about the “death of the dollar.”
But what about now? Should you even bother with foreign currencies when the dollar is rallying? After all, it’s not easy to buy foreign currencies when everyone else is selling. It’s a lot like bottom-fishing during a prolonged stock bear market.
But let me assure you: It’s still worth it.
Let me explain. As we discussed in the first issue of Currency Capitalist, the dollar has been through five major strong and weak trends since President Nixon took us off the gold standard in 1971. This means that even if the dollar is bouncing in the short-term, we will still hit another weak dollar trend in the future.
This means, as a long-term investor, you should still be looking at foreign currencies for the long-run when the dollar is strong. In fact, diversifying into some foreign currencies actually puts you in the best position for the next wave of dollar weaknesses.
It’s the ultimate value investment. Buy foreign currencies on dollar strength, you can add more foreign currency exposure to your portfolio on the cheap. Think of it as buying your favorite blue-chip just ahead of its next rally.
In the coming months, we’ll tell you more about how to play this short-term dollar strength with foreign currencies.
Meanwhile, Across the Pond: Why the Pound Massacre Will Continue
In the September issue of the Currency Capitalist, I pointed out the rot growing on the vine in U.K’s economy. At the time, my fellow currency expert, Jack Crooks, recommended a short position in the U.K. pound sterling.
Well, two months later, the sad beat goes on for the United Kingdom. The Brits are still fighting a banking crisis that mirrors our banking crisis here in the U.S. Don’t forget that the Bank of England was the first to nationalize a lending bank, Northern Rock. Now, they’re leading other European nations in that direction, as other governments swoop in to save their country’s banks.
The U.K. economy continues to teeter on the brink of a recession. But the Bank of England still isn’t stepping in to cut rates aggressively. The Bank of England did participate in the Fed-engineered coordinated rate cuts in October. Besides that, the bankers at the BOE have been dragging their feet about cutting rates.
However, I believe the Bank of England is almost done stalling. They’ll cut rates again soon. When they do, these further rate cuts, along with all the rot on the economy’s vine, should be enough to push the pound sterling further down the slippery slope.
In addition, the U.K. is now tied up with all the mess in Iceland! U.K. citizens had deposits on the books of Icelandic banks when the Icelandic banks all went belly up. The
Icelandic government froze all those British accounts until they could sort through the paperwork.
This riled the U.K. citizens, and pushed the U.K. government to take up the fight on behalf of their citizens. As a currency trader with clients who bought Icelandic krona, I am quite aware of what problems you face when you try to recover funds from defaulted banks that the Central Bank now runs!
So, it sure looks to me as though the U.K. pound sterling is in for some additional weakness. Anyone shorting the pound will continue to be rewarded in the months to come.
Iceland: What You Can Learn From the Great White Meltdown
For a smaller country, Iceland has definitely made a splash lately — unfortunately, for all the wrong reasons. This small country recently hit the newspapers and news programs around the world when Iceland experienced their own national financial crisis. No doubt the sudden spotlight on this small country left many people scratching their heads and wondering where in the world Iceland is!
The Iceland story is one for the ages folks. Since it’s a currency story gone bad.
Iceland — better known for its geothermal hot springs, abundant fish, and all-night raves — quickly became the first and foremost casualty of this economic and financial meltdown.
The country is bankrupt, and the Central Bank had to take over the country’s largest banks. I have no idea how they managed it, but apparently these banks owe more than US$60 Billion overseas… That’s almost six times the value of Iceland’s annual economic output!
Let’s look at how this all came to be in Iceland. To understand how it all began, we need
to go back just a bit…
For the last few years, Iceland Prime Minister David Oddsson pushed to implement a radical program of privatization, tax cuts, reduced spending and deficits, inflation control and targeting, central bank independence, free trade and exchange rate flexibility. Under his guidance, the Iceland government cut corporate taxes from 50% down to 18%. The major banks were deregulated earlier this decade.
At first, the policies looked as though they were the new way of the future. Iceland’s economy grew, the currency began trading outside of Iceland, and the country even made the Fraser Institute’s Top 10 Economic Freedom Index.
Iceland’s government pushed and soon Icelandic banks grew and began expanding overseas. This is where the cheese began to bind for Iceland. These banks grew too fast and too large. Too big for their britches, as my mother used to say! And it all came crashing down around them, causing a banking crisis that began to show cracks as far back as May this year.
Now, the currency has crashed, and the same government who pushed those banks has now had to sweep in and save them. Meanwhile, the foreigner investors who were wooed by Iceland’s 14% interest rates, are scrambling to recoup any of their cash.
You may be asking, why hasn’t any country or white knight come to Iceland’s aid? Well, with the global problems generated by the subprime/credit crisis going on, not many countries are in a position to play white knight! But still, a few countries still have the capital and the wherewithal to step in and help.
The IMF is expected to step in with a US$6 billion rescue package, but the money is coming from the only countries that have emerged from this credit crunch relatively unscathed — specifically, Sweden and Norway.
As I said in last month’s Currency Capitalist, Iceland’s fellow Nordic countries are some of the strongest nations on earth. They’ve already gone through their own banking crisis in the early 90s, so they were in the best position to assist a fellow Nordic country.
Once trading resumes, don’t bother bottom-fishing this market. Their debt problems are far too large, and the krona has a lot farther to fall before this crisis ends.
Do You Want the Deficit-Ridden Government to Be Your Banker?
I want to get something else off my chest before I end this issue: U.S. Treasury Sec. Paulson’s new program. As I said, last month, he wants to inject billions of dollars into troubled big banks. In return, the government will take partial ownership of these banks. Do you want the government to own your bank? This is not good for the economy either! Can’t you see the Government telling banks who they should make loans to?
Can’t you see elected officials demanding banks make loans to their home districts? This is all set for failure folks… And I don’t like it!
Now I’m turning it over to my colleague, Kat Von Rohr. She will tell you how to take advantage of all these trends emerging in the market…
Have a Wonderful Month!
Chuck Butler, Editor
Throwing the Hail Mary Pass
How to Play the Surprise Surge of the Greenback
By Kat Von Rohr, Managing Editor
If the currency markets were a football game, this would be one of those rare times when the coach tells us to toss out the playbook and throw a Hail Mary pass to win the game.
Let me explain. Usually when you evaluate a currency for the long-run like we do here in Currency Capitalist, you look at the currency’s underlying fundamentals. In other words, you monitor a currency’s interest rates, deficits or surpluses, economic growth, inflation rates, political stability, etc.
Generally, if you have a stable country with high interest rates, manageable inflation, healthy growth rates and a trade surplus, you have a winning combination for a strong currency. And vice versa for a weak currency.
In fact, by those standards, the greenback should still be warming the bench right now. But that’s simply not the case right now, because let’s face it, we’re not just playing your normal game here.
Fundamentals Aside, “A Flight to Safety” Supports the Buck
The credit crisis has pushed all this fundamental analysis to the sidelines. Instead, you have to take into account other factors. Right now, the dollar is rallying because the major players in the market are “deleveraging.” In other words, they’re taking their money out of the foreign markets and running home.
Also, in this panic-ridden market, you have to pay attention to how the major players and analysts view certain currencies. Right now the major industry players are running scared back into the debt-ridden dollar with their investment money. In fact, as the stock market crumbles, these players are repatriating their funds even faster and pushing the dollar up even further.
You could say these industry players are throwing the Hail Mary pass. As a result, the dollar is soaring higher and faster than anyone could have imagined just six short months ago.
Short-Term Profit Play
Here at Currency Capitalist, we’re dedicated to giving you long-term plays. For the dollar, unfortunately that means ways to profit from its weak fundamentals. But that doesn’t mean you have to ignore this short-term dollar bullish trend while traders around the world are fleeing into the underdog dollar.
Fortunately, there’s an easy way to take advantage of this intermediate-term bullish dollar trend. This month, we’re recommending a fund that tracks the dollar index. It’s easy to buy and should be easy to sell once the dollar starts to show its true colors once again.
Recommendation: Buy the PowerShares DB U.S. Dollar Index Bullish Fund (AMEX:UUP). You can purchase it right on the AMEX through any full-service or discount broker.
As the Dollar Soars, Our Pound Short Pays Off
In the Forex market, there are always winners and losers.
Right now, the dollar’s gain is the British pound’s loss. As Chuck said, the British economy is now experiencing their own version of the subprime credit crisis. They’ve already had a run on their banks. The Bank of England has also been rather slow to pull the trigger and cut rates. That’s a problem in the long run.
Long story, short: While this credit crisis is pumping up the dollar, it’s also eating away at the pound’s fundamentals. And the British pound is already showing the cracks in the British economy.
As we went to press, the pound fell to its lowest against the dollar since 2002. Analysts are predicting the once mighty US$2 pound could plummet to US$1.58 before it finally throws the brakes on this freefall.
But the good news is our British pound position is paying off. We’ve been shorting the
CurrencyShares British Pound Trust since we started this portfolio in September. Since then, this short pound position has returned 6.22%.
Please continue to hold this short pound position for now.
Your Questions Answered: How Much Do You Need to Trade?
Since we first launched this portfolio three months ago, I’ve received a couple questions about how much money you should allocate for our Currency Capitalist portfolio.
Of course, it depends on your risk tolerance. We’re taking long-term positions. You have to take a look at each trade and see how it fits your overall investment goals.
However, as a general rule, we recommend you allocate 20% of your long-term portfolio to currency trades.
