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The Dollar's Problem

Federal spending is likely to drive the greenback lower in the near term, but the long-term view isn't so clear.
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Editor's note: The following article was originally published as two RealMoney blog entries, on 10/22/09 and 10/23/09. It is being republished as a bonus for TheStreet.com readers. Click here for information on RealMoney, where you can see all the blogs, including Don Dion's -- and reader comments -- in real time.

NEW YORK (

TheStreet

) -- Betting against the U.S. dollar has become extremely popular in recent weeks. It's an axiom in investing that when an asset rises or falls greatly in price, only then will it become widely popular to be bullish or bearish on it.

No one was interested in gold at the height of the dot-com boom, when it could be had for $250 an ounce. And most folks still weren't interested throughout the 2000s. Since the financial crisis began in 2007, gold has become an increasingly popular asset for a variety of reasons.

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has become the second-largest exchange-traded fund in existence, behind only

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.

Similarly, investors appear to realize the dollar is weak all of a sudden, even though the dollar has been in decline since 2000. At that time, the dollar was worth more than one euro, while today it fetches about 0.67 euros.

Still, one of the best trading and investing maxims is, "the trend is your friend." I hold

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as part of some client portfolios and it has performed decently as the dollar declines. Aggressive traders may prefer more volatile currencies, such as the Australian or New Zealand dollars, or emerging-market currencies.

Recently, traders have been focused on which countries will raise interest rates. The Australian dollar rallied against the greenback after the Australian central bank increased rates on Oct. 6, and the pound rallied this week after Mervyn King, the Governor of the Bank of England, wrote in a newspaper opinion article that U.K. interest rates would have to rise "at some point".

The U.S. central bank is seen as willing to hold rates low for much longer than its peers, and that has made the dollar the choice of the carry traders, who borrow in dollars and purchase assets with higher yields.

On the flip side, the sum of money supply and credit hasn't been growing, and the

Federal Reserve

wants to reverse its liquidity injections and end quantitative easing. The policy change is starting right now and will pick up steam as more programs peter out, unless the Fed extends them.

Short term, the carry-trade-driven trend will continue to deliver small gains until something reinforces or stops it in the longer term. The trade has become more crowded, which increases the chances of a correction, but it doesn't mean it signals a reversal. Still, dollar-positive forces are building and investors should be prepared for a surprise correction.

The biggest driver for a weaker dollar is the U.S. government. The politically easy solution to a debt problem is to create inflation to lower that debt over time, but the federal government is borrowing way too much money. A country can't get out of debt by going deeper into debt.

One way of measuring the potential impact of U.S. borrowing on future inflation that is making the rounds in the blogosphere comes from Peter Bernholz, a professor at the University of Basel, Switzerland. His work was cited by hedge fund Hayman Advisors in a letter to clients mentioned in this

Atlantic blog

.

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In a study of inflation and hyperinflation, Bernholz found that the worst cases of hyperinflation begin when a government borrows more than 40% of its expenditures. Hayman noted that the U.S. is at that threshold.

It's unlikely that the U.S. will experience a hyperinflation, one data point aside, but it is the federal government that is most important here, not the

Federal Reserve

. The federal deficits and economic policy are the biggest threats to the value of the dollar.

The bullish side isn't without arguments, though. The most obvious is that foreign governments do not want a weaker U.S. dollar. It means painful economic adjustment to their export models, and we've already seen Taiwan and Brazil, to name two, try to stop the rise in their currencies.

The Fed is exporting inflation via the carry trade, and that is showing up as asset inflation in emerging markets. The weaker the dollar becomes, the more central banks will be trying to weaken their own currency against the dollar in order to pop asset bubbles.

Another factor is the demographic and financial position of foreign countries. Europe and Japan are in much worse shape than the U.S. when it comes to government debt, demographics and future welfare liabilities. The

Telegraph's

Ambrose Evans-Pritchard wrote about those risks recently in

a blog entry

that was somewhat bullish on the dollar, and hedge fund manager David Einhorn mentioned those risks as part of a case for being bearish on all currencies and bullish on gold.

Lastly, the popularity of Ron Paul's effort to audit the Federal Reserve shows that inflation is already politically unpopular. The debt limit needs to be raised by the Senate in order for Treasury to continue borrowing, but consider the following, reported by

Politico.com:

"

Sen. Evan Bayh (D., Ind.) and nine other Democrats sent a letter to Senate Majority Leader Harry Reid (D., Nev.) last week that called on Congress to approve a "special process" to control the deficit -- warning that adding trillions more dollars to the country's credit card could force a sharp rise in interest rates and cause the price of goods and services to decline while limiting the country's ability to act on a range of pressing issues."

Politico.com

reports that the GOP leadership believes all 40 of its senators will vote against an increase in the debt ceiling. If 10 Democrats join them, it leaves it to Vice President Joe Biden to break the impasse and put the rising deficit squarely on the shoulders of the Obama administration, or it means Democrats must cave into demands for more responsible fiscal policy.

It often pays to be a contrarian in financial markets, but not a mindless one. The trend is currently in favor of a weaker dollar, and that's what is likely to pay off in the near term. Forces are building for a short-term reversal however, with sentiment reaching an extreme and money and credit supply not cooperating.

Longer term, a big move is likely, but the direction is unclear. World governments are flooding the globe with liquidity, potentially leading to much higher inflation and a weaker dollar, confirming the herd and the popular arguments made against the greenback today.

If the dollar reverses, then a few years from now, the herd will be talking about how weak Europe and Japan are relative to the U.S., and they'll want to pile into the dollar. Of course, by then, instead of costing 0.67 euros or 90 yen, a dollar might cost 1 euro or 150 yen.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion owned PowerShares DB U.S. Dollar Bearish.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.