With Billions in Bailout Funds Flowing, the “peso-fication” of the Dollar Continues

The plethora of bank and corporate bailouts, stimulus plans and interest-rate cuts that the U.S. government has produced over the last three months can only lead to one outcome: The U.S. dollar has to decline.

During the crisis so far, the dollar in general, and U.S. Treasury bonds in particular, have been regarded as a “safe haven,” making the dollar strong and pushing long-term U.S. Treasury rates downward. In the New Year, however, this is likely to change – the weight of the added supply of dollars in circulation will be too great for the greenback to shrug off.

Back in November 2007, when I wrote about the U.S. dollar becoming the “Bernanke peso,” I suggested that the dollar – then trading at $1.50 to the euro – would get weaker. Alas, I was wrong: It is currently trading at $1.29 to the euro, although it did reach $1.60 in May. However, I recommended buying not euros, but yen. The chaos of 2008 has reversed the decline in the dollar against the euro, but not against the yen, which has reached Yen 92.8 = $1 compared to a rate of Yen 114.8 = $1 when I wrote the piece. A gain of 24% against the dollar is not bad, and indeed I defy you to find a stock market that has done as well over that period.

The fundamentals tending to weaken the dollar remain. The U.S. trade deficit was $57.2 billion in October, which annualizes to $700.3 billion – down but a little from the 2006 peak of $758 billion. Although the recession and recent sharp decline in the value of U.S. oil imports will reduce the U.S. trade deficit further – perhaps to $500 billion annually – there is still no reason why foreigners should continue to so highly rate the currency of a country that is running a $500 billion balance-of-payments deficit, and a $1 trillion budget deficit.

After a pause during the summer, the U.S. money supply has begun rising again rapidly. The excess money has flowed into Treasury bonds, sending the yield on the 10-year bond down to a recent 2.71%. The distortion in the market can be shown by the yield on the 10-year Treasury Inflated Protected Securities (TIPS), which was 2.44%; that combination of prices said that investors expect U.S. inflation to average a mere 0.27% annually over the next 10 years.

Clearly that’s nonsense; the explanation is that yields on long-term Treasury bonds have been driven far below their economically appropriate level. In other words, U.S. Treasury bonds are currently benefiting from a bubble, and like the bubbles that we’ve seen in Japanese stocks, real estate, U.S. tech stocks, the American housing market and global commodities, this bubble, too, will ultimately burst.

The budget deficit in the 12 months through to September was $455 billion, but that’s expected to expand to close to $1 trillion in the year to September 2009 – and that’s even before President-elect Barack Obama’s stimulus plan, which is expected to cost at least $500 billion, and could possibly cost that much a year over several years.

If that’s surprising, consider this: The U.S. budget deficit was $237.2 billion in October 2008, a record monthly figure. That puts a huge strain on the U.S. Treasury Department’s financing capacity, and will probably result in the U.S. Federal Reserve printing yet more money, since the alternative would be for the huge amounts going into Treasuries to choke off demand for private investment – not the desired objective. With more money being printed, inflation is likely to soar and the dollar to weaken.

Net foreign purchases of long-term U.S. securities declined to $793 billion in the 12 months to September 2008, from $1.03 trillion in the previous year. Of those purchases, Treasury bonds and notes represented $385 billion, up from $192 billion in the previous year, while purchased corporate bonds shrank from $447 billion to $168 billion. Thus, the “flight to quality” has so far been enormously helpful in enabling the U.S. Treasury to finance its growing budget deficit; in October and November it will doubtless have been even more so.

Once the inflow into U.S. Treasuries slows, or the huge volume of Treasuries issued simply overwhelms it, the dollar will weaken and Treasury yields will rise. At that point, there is likely to be a stampede for the exits from the Treasury bond market, which will be self-reinforcing. As a wise investor, you could prepare for this stampede in four ways:

• First, you could have a modest holding of the Rydex Juno Fund (RYJCX), the price of which is inversely linked to T-bond prices (the fund shorts Treasury bond futures.). The fund has had a poor record since its inception in 2001, and it probably makes little sense to put too much money in it. However, given the scenario we’ve sketched out here, the fund will do a lot better in 2009.

• Second, you should have bond, cash and stock holdings in foreign currencies, particularly the euro and the yen (but not British pounds sterling; with a housing bubble and a bloated financial sector, Britain has many of the same problems as the United States). Aside from foreign-currency-denominated stocks and bonds, you may want to consider a foreign-currency-deposit account through EverBank, which offers foreign-currency certificates of deposit (CDs), albeit at low interest rates, at present – only 1% on a 12-month Euro CD for example. [Editor’s Note: EverBank also offers a product called the EverBank Asian Currency Portfolio. Readers can find out about all the bank’s products by contacting the folks at EverBank’s World Currency desk at (800) 926-4922. Be sure to mention product ID #12534. We should also mention that Money Morning has a marketing relationship with Everbank, but that’s only because we believe in its products.]

• Third, you should hold some gold, which is likely to profit from a dollar collapse – for example through the SPDR Gold Trust fund (GLD), which has ample liquidity, with $17.6 billion outstanding, and which tracks the gold price directly.

• Fourth, you may make a modest (no more than 1% to 2% of your portfolio) speculation in currency options, which are traded on the Philadelphia Stock Exchange. Since the yen has already enjoyed a considerable run against the dollar, the best speculation might be to purchase out-of-the-money euro call options, which will rise in price once the dollar starts falling against the euro. Personally, I prefer to buy the longest possible options available, to give the market time to move in my direction. So, I would go for the September 140s (PHLX: XDEIH), giving nine months to maturity at a strike price about 8% out of the money (the euro being currently at $1.29). Currently these are trading at $4.55 offered, so you would have to pay $455 for each 10,000 euros on which you purchased an option. Your break-even would thus be $1.4450. If the euro is trading above that level next September, you would gain, so if it matched its May peak of $1.60, you would make $2,000 per contract. If it was below $1.40, you would lose your investment of $455 per contract.

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