David R. Kotok

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Keep your eye on the U.S. dollar

http://www.NewsAndOpinion.com | Most of us conduct our financial affairs entirely in American dollars. Those who travel abroad know about using ATM machines to get the foreign currency we need at the best exchange rate. When we travel we may compare a few prices with the last visit. Otherwise, currency rates of exchange are not much of an influence on our daily personal agendas.

Until, we look beyond our individual transactions and into the international realm. Then it all changes.

Fact: our dollar is weakening. That will mean higher prices for us when we buy something imported. It will mean lower prices abroad for our exports. A little imagination can quickly determine who wins and who loses when the currency exchange rate rises or falls.

In the capital markets there is another and extremely important influence. We see it in the realm of international asset allocation. Global portfolio managers are constantly deciding how much to invest in each currency and in each country.

Until recently the dollar clearly was the king. Foreign investment flows into the United States approximate 1 1/2 billion dollars a day. There was no difficulty attracting them.

This is now changing. We still need the $1.5 billion each day; the problem is how to get it.

Foreigners are seeking ways to diversify out of their concentrations in dollar denominated investments. They are heavily over weighted in the dollar and some of them are beginning to worry about diversification.

We believe this trend is in its very early stage and has a long way to go. We think the strongest currency in the world will be the Swiss Franc but inflows into that currency will be limited by the market size and perhaps eventually by the Swiss government. There is a precedent for that; years ago and in a prior dollar crisis, Switzerland imposed a negative interest rate on bank deposits as a way to discourage international inflows.

We believe that the euro is destined to benefit the most. It is the default alternative to the dollar. Rational folks will not want to make bets on the Japanese yen.

We are raising our target for the euro to 1.20 by 2004.

We have reforecast the euro three times since it hit 85 cents, most recently at http://www.cumber.com/comments/111302.htm. Each time our forecast has been reached much sooner than anticipated. Now the euro is 1.06 1/2 level and has reached 1.07 intraday. This is without the speculative positions which can be established against the dollar by borrowing dollars at present low interest rates and positioning the proceeds in euro denominated securities.

All this means foreigners will be more reluctant to buy U.S. financial assets and more inclined to sell when they can. U.S. stocks and bonds face a possible escalating selling trend from abroad.

Our stock markets can still rise under these circumstances but they will be doing so with a headwind. Most of our stock price momentum is driven by domestic U.S. investors. They're currently given a huge incentive due to low interest rates and other stimulative policies. But they will not get help from foreigners. We expect them to be net sellers as the dollar continues to decline in value.

Bond investors face a different issue. A massive amount of foreign investment in the U.S. dollar takes the form of debt instruments. If these foreign holders start to liquidate, a rout can occur in the U.S. bond market. If they just stop buying, that alone will cause bonds to decline in price and yields to rise. This comes at a time that U.S. Treasury issuance is rapidly expanding due to the federal deficit.

The amount of foreign adjustment out of the dollar and into debt instruments denominated in other currencies is the big question facing bond investors in 2003. We believe that markets are not prepared for what may become a substantial sell off in bonds.

Where can bonds go?

We'll use the 10-year benchmark treasury and make a few estimates about forthcoming U.S. inflation (let's use 2%) and U.S. real economic growth (let's use 3%). We need to add something because the federal deficit is growing toward 3% of our GDP and because our current account deficit is still approaching 5% of GDP.

Put this together and one gets a 5 to 5 1/2% yield on the 10-year treasury note. That is without any overshooting. We expect to see that rate in the marketplace within 12 to 18 months.

All this means a dramatic change in the prices of high grade bonds.

JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.

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