Why Investors Should Bet Against the Dollar

Why Investors Should Bet Against the Dollar

Three days after the Reserve Bank of Australia unexpectedly raised interest rates, the monetary policy committee of South Korea’s central bank held a meeting. The Oct. 9 gathering was closely followed because the Australian move raised expectations that other central banks will also tighten. Korea held the line. Citing “uncertainty as to the economic growth path,” the Bank of Korea kept interest rates at an ultra-low 2%, the result of six rate cuts over the past year.

Still, it is only a matter of time before Korea follows Australia’s lead. So will the People’s Bank of China, the Reserve Bank of India, Reserve Bank of New Zealand, the Monetary Authority of Singapore — and perhaps several months down the road, the European Central Bank. As economies recover and jobless rates fall, most policymakers will raise interest rates to head off inflation that could result from the massive fiscal stimulus spending launched by governments around the world to combat the global recession.

Most will raise rates — but one very conspicuous central bank is unlikely to follow suit. With the U.S. jobless rate at 9.8% and still rising, the U.S. Federal Reserve cannot risk a rate increase anytime soon despite the danger of inflation. Raising rates would add to the burden on American businesses, particularly small-and medium-sized enterprises that account for the majority of U.S. jobs. Higher rates would also make mortgages, credit card debt and other forms of personal financing more expensive, further crimping consumer spending, which accounts for the bulk of U.S. GDP.

The inability of the Fed to raise rates along with the rest of the world is more bad news for the flagging dollar, and investors everywhere should pay attention. It now makes more sense to get out of the greenback and park money in higher yielding currencies, since foreign-currency deposits will earn more in interest and could make additional foreign exchange gains. Interest rates in Australia last week were raised a quarter point to 3.25%, and could go higher still. The unemployment rate down under recently fell to 5.7%, leading economists to expect another rate rise on Nov. 3. Meanwhile, the target range for the U.S. federal funds rate is 0 to 0.25%.

The Australian dollar jumped 2.6% versus the greenback after the rate hike was announced. The U.S. dollar also continued to fall against the euro, which ended the week at $1.47, up 1.2% from before the Australian move. Like the Japanese yen, the dollar has effectively become a carry-trade currency. People borrow in the American currency and use the proceeds to buy the Australian dollar, profiting from the interest rate differential and also the greenback’s downward spiral.

Fed Chairman Ben Bernanke tried to talk up the dollar last week by declaring that the central bank will tighten monetary policy in order to avert inflation. But he also emphasized that the Fed is committed to keeping interest rates at near zero to help the battered economy. In the tug of war between those two antithetical positions, it’s virtually certain that near-zero rates will win for the foreseeable future.

Another winner is gold, which breached the $1,000 level in September as the dollar started to weaken and then hit three record highs after the Australian announcement, ending the week at $1,049. Gold is still regarded as a hedge against a weak dollar and also against inflation. No one is listening to Warren Buffet, who describes the metal as having no utility, something that gets dug out of the ground, melted down, and then buried again in another hole guarded by people paid to do the job. “Anyone watching from Mars,” says the Sage of Omaha, “would be scratching their head.”

Then again, the hypothetical Martian would also scratch his head at the notion of paper money. The dollar has no intrinsic value. It has become the world’s storehouse of value because it is backed by the economic might of the U.S. If another super economy emerges, be it the European Union, China, India, Brazil or Russia, then that new power’s currency could replace the dollar as the world’s reserve currency, just as the dollar replaced sterling in the last century.

The growing differential in interest rates is only one element in this process. On the day Australia raised interest rates, Britain’s The Independent newspaper reported that the Gulf Arab states and China, Russia, Japan and France are working to end the use of the dollar in oil trading by 2018. Citing “Gulf Arab and Chinese banking sources in Hong Kong,” the newspaper said the plan is to price oil using a basket comprising gold, euro, yen, renminbi and a new unified currency for the Gulf Cooperation Council countries.

The report sounds fantastical on its face and Muhammad al-Jasser, Saudi Arabia’s central bank governor, lost no time in branding it “absolutely incorrect.” But the fact that these assertions are being made at all shows how seriously confidence in the dollar has been shaken. The world’s central banks are starting to shun the dollar. According to Barclays Capital, nations reporting currency breakdowns of their reserves invested 63% of new cash in euro and yen in the quarter to June 2009. It seems the U.S. will have to resign itself to a weaker currency until its economic house has been fully repaired.

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