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Five Things You Need to Know About the U.S. Dollar


What's really going on with the dollar, and why do we care whether it goes up or down in value?


Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:

The greenback just can't catch a break.

Despite recent positive comments (or, at least, less negative comments) from George Soros and a reasonable rebound off the March lows, the dollar is still doomed, according to conventional wisdom.

So what's really going on with the dollar? And why do we care whether it goes up or down in value? Isn't the dollar I'm holding today the same as it was yesterday? Why can't the Fed just print more of them? Let's take these questions one by one and see if we can reach an investment thesis that runs contrary to conventional wisdom.

1. Q: What is a dollar anyway? What does it mean?

A: The dollar is simply a banknote issued by the U.S. government that is mandated by law to be used as legal tender for all transactions. Although the dollar was once backed by gold, today it is backed simply by the government's promise that it will be convertible in an exchange. Got faith? Good, you'll need it, because faith is the only thing that separates a blank sheet of paper from a dollar bill that is exchangeable for, say, a banana.

2. Q: OK, I've got faith aplenty. So where do all our dollars come from, and why can't the Federal Reserve just print more?

A: The Fed can print money. And it does quite often. But every dollar created dilutes the value of a dollar already in circulation, causing it to weaken. Of course, we don't notice this dilution immediately unless we travel outside the country, and if everything we consumed was produced in America, we probably wouldn't even notice a weak dollar at all. But the reality is we still buy many goods from overseas producers and spend more dollars on those goods than we receive for goods produced in the U.S. That's called a trade deficit.

3. Q: So, we're spending more than we're making, and the Fed is printing money to make up the difference. How does the Fed do it?

A: The Fed "prints" money through three mechanisms. The easiest way is through the Fed's open market operations, through which the Fed literally buys and sells Treasurys that are trading in the "open market." If the Fed buys Treasurys, then the dollars it uses to buy them become available to banks to lend. If it sells Treasurys, the dollars get taken back.

The second mechanism is lowering the percent of deposits banks are required to have on hand, thereby increasing the pool of available money to lend.

The third is through its "discount policy." The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility. The Fed can grow money by reducing the discount rate.

Dollars are literally printed by the Bureau of Engraving and Printing.

4. Q: Trade deficit, weaker dollar -- I kind of get it -- the Fed has to print more money. But the more money it prints, the weaker the dollar gets, right? So who is paying for all of this and what's the connection with foreign central banks?

A: As a group, we Americans spend more than we save, both individually and collectively as a government, so that money has to come from somewhere. This raises a serious question. Because the more money the Fed creates, the weaker the dollar gets, how do we get all these dollars to spend without collapsing the currency?

One way is through the purchases by central banks of countries like China and Japan. We have to "sell" our Treasury bonds to countries willing to buy our debt, paying them interest for financing our spending. Foreign governments all over the world also use the dollar as a foreign exchange reserve, allowing them to control their own currency, increasing or decreasing it compared to other currencies, and to maintain the stability of their currency in the event of an economic shock.

Because the dollar is perceived as the most stable currency in the world (note: the key word here is "perceived"), countries are willing to finance our spending by purchasing dollars and bonds. But, if they begin to perceive they are not being adequately compensated for the risk of holding our debt, or if their dollars are depreciating faster than they like, these countries will demand a higher interest rate to buy our bonds. So, a weak dollar can actually lead to higher interest rates! That affects you, Mr. or Ms. Homeowner-Credit Card Spender-Business Professional-Student!

5. Q: Here's the bottom line: In the simplest terms, what are the advantages or disadvantages of a stronger or weaker dollar, and how do I play it?
A: Here's a summary:
Weak Dollar: Advantages

  • It's easier for U.S. companies to export goods because foreign currencies can buy "more" against the weaker dollar.
  • Tourism increases because foreign visitors find it less expensive to visit.
  • To an extent, foreigners will view U.S. investment opportunities more favorably because they can buy more for their yuan/yen/euro/pound, etc.

Weak Dollar: Disadvantages

  • Consumers see higher prices. We don't notice this because the Chinese yuan is tied to the dollar in a tight range. And most of our imports come from China.
  • There are higher interest rates, i.e., higher cost of money to consumers.
  • It's more expensive to travel abroad.

Strong Dollar: Advantages

  • The prices for imported goods are lower.
  • U.S. investors can buy foreign assets and investments at lower prices.

Strong Dollar: Disadvantages

  • It's harder for U.S. companies to compete abroad.
  • It's more expensive for foreigners to visit the U.S.

So how do you play a strengthening dollar? It used to be that unless you were a currency speculator, dollar strength and weakness involved an indirect play via companies with strong international sales, such as Boeing (BA), Coca-Cola (KO) or Yum! Brands (YUM).

Now there are many more alternatives. Two exchange-traded funds that allow investors to make short-term bets on the dollar's direction are available through PowerShares. The DB U.S. Dollar Bullish Fund (UUP) , as the name suggests, allows you to bet on the dollar appreciating, while the DB U.S. Dollar Bearish Fund (UDN) allows you to bet against the dollar.

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No positions in stocks mentioned.

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