TFTF

King Dollar and the Guillotine

March 15, 2002

Today we are going to get practical. I will show you where to double your money market returns with government guarantees. We will look at one of my favorite US banks which is paying up to 7.75% for three-month CDs. (And yes, of course there's a story behind that number.) As promised for weeks, we are finally going to look at the prospects for King Dollar to remain on the throne.

With all the action going on in the bond market, I was tempted to postpone this dollar oriented letter one more week, but the story on the dollar is just as important, and I smell a move beginning to happen. Next week, we will look at the bond market. My favorite aggressive US bond fund - the Target 2025 fund -- is down over 6% for the year. Is it a good buying opportunity, or is it time to bail? Let me just say, I am still in the fund. One of the best bond timers in the US, Don Peters, is still a believer. Stay tuned.

Quick note and then on to the dollar. Evidently some of you (and the rest of the market) agreed that Williams Energy (WEG) is a good income opportunity. It is up 10% since I wrote about it last week.

King Dollar and the Guillotine, or How to Profit from the Drop in the Dollar

I have been bullish on the dollar for years, for a variety of reasons. We have seen an extraordinarily powerful dollar move in the past five years. My 2002 forecast saw the dollar gaining ground against the yen and staying flat with the euro. Only three months into the year, I want to make an amendment to that forecast. This may be one you want to try and profit from.

Two weeks ago, I wrote that a weakening dollar would be bullish for gold, and suggested a new way to get into the gold markets. (New readers can read this in the

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Gold Forecast, March 1, 2002.)

Today, I want to go into why I am concerned about the dollar, and specifically the dollar against the Euro. Currencies are complicated things. They are subject to supply and demand, just like any commodity. If this were the only issue, currency trading would be a whole lot easier. But they are also manipulated, for a host of political and economic reasons.

Concern #1 - The Trade Deficit Widens

Dollar bears have been bringing up the bug-a-boo of the trade deficit for years as a reason the dollar should come crashing down. But it hasn't. Like the Energizer Bunny, the dollar has kept going and going and going.

How can the United States spend $400 billion dollars a year more than it exports and the dollar keep getting stronger? There is a simple reason. Foreigners want dollar denominated assets. They buy US stocks and bonds and US businesses. We buy their stocks and bonds and businesses. But world demand for our stocks, bonds and businesses has been much stronger than our desire to buy foreign assets.

If a European investor wants to buy a US stock, or a European company wants to buy a US company, they must take their euros and buy dollars in order to make their purchase. When done on a large scale, that makes the value of the Euro go down and the dollar up if US investors don't want an equal number of euros.

The trade deficit is running roughly at $400 billion per year. That means that foreign investors must buy $400 billion of our "stuff" to keep the current account balance all square. Morgan Stanley estimates that the US trade deficit will grow to over $600 billion in 2003, less than one year from now. Will foreigners want $600 billion of US stocks and bonds and real estate and companies? There are serious warning signs they will not.

In the period 1990-95 average annual European dollar flows from mergers and acquisitions (M&A) was only $10 billion. In 2000, Europeans invested over $600 billion in the US. Taking away US investments in Europe it was a net $214 BILLION to the advantage of the US. If I have the calculations right, that alone financed half of the trade deficit.

As long as foreigners keep buying our assets, the dollar will remain King. But there are a few cracks showing up.

Announced merger and acquisitions for February were just $7 billion, down sharply from January which was $23 billion. Last year their was $90 billion announced for the first two months. This is a HUGE drop-off.

Why have things slowed down? First of all, profits are down, so the basic money needed to buy companies is dramatically reduced. Further, banks are reluctant to lend for acquisitions which are not showing positive earnings potential. I have reported that loan requirements are getting tighter. Banks already have enough bad loans, thank you.

Companies are reluctant to enter into deals with their stock prices down, or from a position of weakness. Even with an improved economy, profits have not started to rebound. I predict that investors are going to be disappointed six months from now when profits do not match analysts predictions.

European and other countries have been financing our deficit for years. The last two months says the music may have stopped. If it has, there will be a scramble for chairs; the bloated dollar will not be fast enough to find one.

Concern #2 - The US stock and bond market

Much of the rest of the deficit has been financed by the desire of foreign investors to buy US stocks and bonds. Are we going to see US stocks advance 10-15% this year? I doubt it, and from the tone of my mail, so do you. This is a sideways year at best, as companies must demonstrate they can produce actual profits to justify their sky high valuations.

Further, you are beginning to see investor flows to international stocks, many of which are more reasonably valued. The huge flow of net dollars into the US stock market seems to be the weakest link. If it is, the dollar will be asked to sit down.

Concern #3 - Trade Wars

In the face of a world-wide recession, the latest increase in steel tariffs is unsettling. I know the reasons the President imposed tariffs. I know they are not as high as they actually seem o the surface. I know that foreign companies are dumping.

But it is a hard signal from the country that champions free trade. (Not to mention the fact that it is essentially a tax on US consumers when they buy anything made of steel. It will cost more jobs than are saved in the steel industry.) Joe Quinlan of Morgan Stanley says, "Steel joins genetically modified food, offshore tax subsidies, beef, bananas, and Iraq as flash points threatening to undermine the US's relationship with Europe. Investors should be mindful of the fact that as the rhetoric and ill-will rise, at stake is the cohesion of the transatlantic economy, accounting for roughly 40% of world output."

The front page of the Wall Street Journal today tells us that a 30% duty has been put on $12 Halloween costumes (made in China) because some judge now equates them with tuxedoes and fancy dresses, which are subject to duty. I know you will be surprised to find out that a US manufacturer brought suit to protect their higher cost products made in Mexico. No big deal, except that US consumers will now pay $100 million or more extra for their kids costumes. Tariffs are a tax on US consumers, let us make no mistake.

Taken one item at a time, this is not a big deal. But combined, it is a pattern I do not like. It reminds me of the simple beginnings of the trade wars in the 1930's.

Concern #4 - Black Market Pressures Ease

Early last year, I wrote about how the black market in Europe was helping boost the dollar. Europe is notorious for its black market cash economy. When the various governments decided to go to the euro, they also saw a way to hurt those who avoided taxes in the cash economy. They required banks to report anyone exchanging large amounts of francs or marks or pesos for the new Euro. All exchanges of physical currency started on February 1 of this year and have to be finished by the end of March. Many people rushed to get ahead of the crowd and bought cash dollars. After March, they will buy euros with their dollars. The estimates for the underground economy in Europe are enormous. I think this has been an artificial drag on the euro and a prop to the dollar.

Concern #5 - Central Bank Pressures

Today, there is only one reserve currency that Central Banks want to hold, and that is King Dollar. Who would want the yen? The Euro has been in a bear until recently. I think that changes. The Central Bank of China has clearly indicated they intend to hold euros as well as dollars. The head of the Chinese Central Bank is a known dollar bear because of our trade deficits, and I think it is likely that other central banks follow suit, at least with some of their holdings.

Concern #6 - US Policy Switch

The US has had a strong dollar policy ever since the Treasury Secretary Robert Rubin made his announcement in 1995. Bush administration officials have confirmed this, although with not as much conviction, in my opinion. The strong dollar has been a large part of the reason why US manufacturers are having so much trouble competing, even with Mexican labor.

Chuck Butler of Everbank (more later) noticed the same thing I did emanating from the Greenspan speech last Wednesday. "At one point in his speech he expressed concern about the Current Account Deficit, which he views as unsustainable.... The National Assoc. of Manufacturers noticed it because it didn't take them long to come out with a resolution requesting the White House 'to direct the dollar and other major currencies to their equilibrium rates.' "

Equilibrium rates is code for a lower dollars. It is not politically correct in today's climate to be for a weaker US anything, whether it is dollars or hockey teams.

Here is the problem for the Bush administration: If we do not get a strong economic rebound, after all the physical stimulus we have had, the next card they will be forced to play is to stimulate US exports. That is a polite term which means to lower the dollar. I note with interest the irony in such a potential policy. We are routinely critical when another country purposefully weakens their currency. (I will go into what else it means next week, but this week we are focused on the dollar.)

Will the Bush team want to go into 2004 without an expanding economy? We all know the answer.

But on the Other Hand

All this adds up to the potential for a weaker dollar. But as all economists do, let me now shoot holes in my argument, summoning as my key witness: me, or at least what I have written in the past.

I have written many times about what Greg Weldon calls the Competitive Devaluation Raceway: the trend among Asian countries to keep lowering the value of their currency against each other so they can have an advantage over other countries in selling to the US consumer. This has been a strong trend for years.

Further, Japan has clearly announced their intention to take the yen down further against the dollar, despite its recent rebound.

Stephen Roach of Morgan Stanley reports today from an economic meeting in Asia that these countries clearly are counting on the US and US consumers to pull them out of their slumps. Looking for home-grown growth is just not in their play books. Like my son's high school football coach, they only know one play. However, they executed that one play well enough to get them to the play-offs for ten straight years.

The Asian countries have sold to the US, and that play has worked well for 2 decades. Like my son's coach, they ask themselves why should they change a successful plan? The various governments have made it clear they intend to protect their competitive turf and will promote a strong dollar policy. This is clearly bullish for the dollar. I still think we could see a surge of Japanese money into the dollar over this year, unless the Japanese government changes their policy and actually pursues real reform, which does not appear in the offing.

Finally, from a technical trading standpoint, the dollar is looking a little weak. The Bank Credit Analyst writes: "...the fact that both short-term and cyclical momentum (the 13- and 52-week rates-of-change) are diverging negatively with the rising trend in the index warns that the bull market [in the dollar] may be on borrowed time."

Let's go to industry acknowledged currency expert for an analysis. Chuck Butler of Everbank is in charge of their currency trading and World Currency accounts. He feels that the dollar is about 25% over-valued.

He is not predicting a quick crash, however. He thinks, and I agree, that any move downward in the dollar could be just as long and slow as the move up was. In other words, it could last up to five years, although a lot of the movement could come this year and next year as King Dollar is de-throned.

He thinks the Euro will rise in value this year, to $.95. From today's approximately 88.5 cents, that is a rise of about 7%. He also thinks that the euro could go to parity with the dollar within the next 12-18 months, which would be another 5% or so. If that were to happen, simply converting your dollars to euros would mean a 12% rise in the number of dollars. But what if you could get interest on your euros as well, without leaving the US?

How to Profit from a Drop in the Dollar

One of my favorite ways to profit from a drop in the dollar and a rise in foreign currencies is to actually purchase a certificate of deposit (CD) in that currency. Everbank, mentioned above, is an online FDIC insured US bank that will sell you a CD in a variety of currencies. You can get a 3 month CD in euros that pays 2.65%. If the dollar drops, you get an added benefit of a gain on the currency. Of course, if the dollar rises, you will suffer a capital loss. (I should note that the FDIC does not guarantee against currency risk.)

I asked Chuck what are his favorite currency CD's today. He said he liked the:

New Zealand dollar which pays 4.45% for 3 months. Australian dollar which pays 3.29% for 3 months. The Euro which pays 2.65% for 3 months.> And their multi-currency European Opportunity CD which pays 7.75% for 3 months! (All of the above numbers are annualized.) He likes the New Zealand and Australian currencies because of the economic rebound in those countries. I like the Australian dollar as well because of its well-known connection to the price of gold, of which I am a recently converted bull.

He likes the Euro, as noted above. But of special interest is their European Opportunity CD. This CD invests in the currency of three countries which are working on getting into the European Monetary Union by 2004: the Czech Republic, Hungary and Poland. Each of these currencies has shown strength as of late.

In order for them to meet the requirements for admission to the EMU, they have to meet a number of economic targets on inflation, trade balances, fiscal policy and so on. If they meet these targets, it would be a big positive for each of these countries and their respective currencies.

Additionally, these currencies are very sensitive to the Euro. If the Euro rises, then they are likely to rise as well.

Interestingly, this CD pays more for the 3 month than the 6 month. When I quizzed Butler about that, he said that long term rates are coming down, and that the expectation is that they will continue to do so, so they offer lower rates on the longer term CD's.

They also offer 3 month Mexican peso CD's which pay 6.40%. My good friend Lynn Carpenter of the Fleet Street Letter is a big fan of Mexico. As a frequent visitor to Mexico, it has not escaped my attention that the peso has been even stronger than the dollar. The policies that the government is pursuing is likely to keep the peso strong. I will try to get a link to her report for you next week. It is worth reading.

I told you at the beginning I would show you how to double your money market returns. The average US money market is paying 1.14%. Everbank offers a US dollar CD which pays 2.5%, against the national average of 1.75%.

I am good friends with some of the founders of Everbank. Their currency group all migrated from the old Mark Twain Bank in St. Louis, which was the only bank to offer international currency CD's for years. (I should note here that Everbank is a sponsor for my publisher, http://www.InvestorsInsight.com. Hopefully, InvestorsInsight will be able to add currency content to their website similar to Everbank.)

You can find out about Everbank and actually open a CD online. When you open a CD, they will send you by email a report they are preparing called "The Year of the Euro". I have read a preliminary draft, and found it very useful. Opening a CD using their website is easy, just use the number 1511 as a reference code to make sure you get the report.

If you think the dollar is at risk, these CD's make sense. Which CD should you choose? The Euro is the most conservative play. The European Opportunity CD is the most aggressive. You can discern the risk by the interest rate. The higher, the more risk. Since the minimum single currency CD is only $10,000, you could invest in several and spread your risk. The minimum for the Opportunity CD is $20,000, spread among three currencies. Or simply take advantage of their higher US dollar CD rates.

I must confess to liking the Opportunity CD for my aggressive money. These currencies have been slowly strengthening as they get closer to 2004.

By they way, I have known about these programs and Everbank for years. I have not mentioned them before now, as I did not think the opportunity was there. I do now.

Back at the Ranch

We celebrate my daughter Tiffani's 25th birthday tonight with the whole family. It is hard to imagine having a 25 year old daughter. Having her work for me in our management business has been a source of pleasure, and has made the operation much more efficient. I tell friends if I had ten like her, I could take over the world.

It is spring, and that means a lot of good things. The weather is excellent, but instead of hitting golf balls, it is the season to plant tomatoes, flowers and such at the Mauldin home. Next Tuesday my wife and I have front court seats to watch the Mavericks finally end their domination by the Lakers. March Madness is here, and then the NBA play-offs. And the Texas Rangers actually bought pitching this season. Hope springs eternal in Texas. Sometimes it is the simple things that make life so good.

Your hoping to see Shaq finally get attacked analyst,

John Mauldin

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