Weighing the Dollar Alternatives: Part II

In last week’s Money and Markets column, I analyzed the three major liquid currencies as prospective alternatives to the U.S. dollar: The Japanese yen, the British pound and the euro. Fundamentally, they all fell short.

As I explained then, these three don’t offer any appeal over the dollar. That’s because the currency market is a beauty contest where the least ugly wins. And not only is the dollar the least ugly, but it offers refuge when fear and uncertainty grip the markets.

So What about Other Currencies?

Other world currencies may not offer the liquidity to emerge as a primary reserve currency. Nonetheless, I’m frequently asked how they stack up against the dollar. Do they offer opportunities to preserve the purchasing power of your wealth … or at least make for a good trade?

This conditional statement I wrote last week applies to these other currencies as well:

“If the Fed and other central banks around the world fail to remove the emergency stimulus before those measures translate into inflation, then ALL currencies will fall in value relative to hard, tangible assets like gold, real estate and other commodities … even financial assets like stocks and bonds. That’s global inflation.”

That determination will likely be made years down the road. For now deflation remains the problem until global demand and credit growth bounce back, which I think will be a longer, bumpier road than most think.

But, like last week, I don’t want to debate inflation or deflation today, I want to take a look at some other potential alternatives to holding U.S. dollars in a world where dollar sentiment is profoundly negative.

So let’s take a look at …

Dollar Alternative #4 —
The Swiss Franc …

The safety and secrecy of the Swiss banking system has come into question.

The historical safe-haven feature of holding the currency of the neutral Swiss should be an extra benefit these days. But the global nature of the financial crisis deteriorated the safe-haven quality of Swiss francs. And its preferred status has transferred to the U.S. dollar.

Switzerland’s banking system was (and remains) highly exposed to the financial crisis. And, even worse, the global crack-down on tax havens puts the Swiss private banking model in jeopardy.

In addition, the Swiss are printing money at a faster clip than the U.S. and have been intervening in the currency markets to weaken the franc and to attempt to curtail deflationary forces.

The Swiss economy is expected to underperform the U.S. in 2010 and 2011. And interest rates in Switzerland are as low as they are in the U.S. and are projected to follow U.S. rates higher in the coming years, but at a slower rate. Again, the advantage goes to the dollar.

Dollar Alternatives #5, #6 and #7 —
Commodity Dollars …

Canada’s banking system has held up better than its G-7 counterparts. And the Canadian economy has tracked the U.S. economy closely through the recession. Although Canada has a strong performance linkage to the price of oil, the economy has an even stronger link to the general health of the U.S. economy.

That’s why the Canadian dollar has tracked the U.S. stock market in lock-step since the crisis broke out. And I expect that trend to continue. So, if you think our stock market will go higher from here, the Canadian dollar offers a dollar alternative.

The Australia dollar has leaped 60 percent in recent months.

As for the other two commodity-centric currencies … the Australian and New Zealand dollars … there’s only one story worth telling here. It’s Australia. Australia is the bright spot in global currencies. Its economy weathered the global recession the best, and its central bank was the first in the world to raise interest rates … twice.

Australia also happens to be in the sweet spot to take advantage of growth in China and higher commodity prices. So Australia offers an alternative to the dollar, but only after it pulls back from its aggressive 60 percent surge of recent months. And only with an appreciation for the risks … as described below.

Dollar Alternatives #8, #9, #10 and #11 —
The BRIC currencies …

Brazil, Russia, India and China are still emerging economies. And these developing economies tend to come with imbalances and shortcomings that leave them exposed to excessive volatility. Therefore, they should be off-limits as passive, unmonitored currency investments.

In short, the currencies of these countries are high-beta. So when the risk environment is good, these currencies will do better than major currencies. When it’s not, look out.

Just eight months ago Russia was intervening to support the value of the ruble.

For example, just last year Russia spent over a third of its $600 billion in currency reserves trying to defend the value of the plummeting ruble as global capital fled Russia in search for safety. And now, the Russians are talking about capital controls, like Brazil has done, to restrict speculative flows into their financial markets.

What a difference eight months makes. And that’s indicative of the volatile nature of these emerging market countries. And with protectionism picking up globally, the uncertainty surrounding these currencies is even greater.

China’s a different ball game. The managed currency policy in China, which I most recently wrote about in my November 14 column, prohibits the Chinese currency from playing a role globally, anytime soon.

Can China’s currency appreciate materially? Yes. Will it? Not likely. The Chinese will continue to do what’s in their best interest. And keeping the yuan artificially cheap creates plenty of advantages for the Chinese — and disadvantages for the rest of the world.

You Must Respect Risk …

We are in highly uncertain times, and, in my opinion, the markets are far too complacent in assessing risk. Rising stock prices have a way of making people feel good.

But keep this in mind, when considering alternatives to the dollar for the sole purpose of preserving purchasing power of your wealth: There is always the risk of a decline in these currencies, even when a fundamental indicator may seem positive.

Why? Because all of the currencies I’ve mentioned today are intimately tied to the performance of the global economy. And with that linkage, comes risk.

In fact, just last year:

• The Australian dollar dropped 38 percent in three months,

• The Canadian dollar fell 26 percent in one month,

• And the Brazilian real lost 59 percent of its value against the U.S. dollar in a little more than a month.

And if you’re overly concerned about the recent weakness of the dollar, you need to put things into perspective …

The dollar still remains seven percent stronger than it was last year against the euro, 19 percent stronger against the pound and in better position than nine out of its top ten trading partners.

In this investment climate, investor perception trumps fundamentals. When investors feel confident, we see strong surges in global currencies. But when fear sets in, it’s just the opposite … investors look to the U.S. dollar.

Regards,

Bryan

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