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U.S. Dollar Stress Next?

Currencies / US Dollar Jul 28, 2010 - 10:51 AM GMT

By: Axel_Merk

Currencies

The crisis is dead! Long live the crisis! In an attempt to address the debt crises swirling around the globe, policy makers have responded with a mishmash of somewhat questionable approaches:


  • The U.S. has passed a financial reform bill not worthy of its name;
  • The U.S. & Europe have engaged in stress tests that aren’t all too stressful; and
  • China, in an effort to contribute to a more balanced global economy, has allowed its currency, the yuan, to appreciate by a whopping 0.7% in recent weeks (year-to-date as of July 25, 2010).

In the meantime, the markets have been subsidized with fiscal and monetary stimuli:

  • The Federal Reserve (Fed) has printed more than $1.5 trillion to jump start the economy;
  • Congress is engineering trillion dollar deficits.

Policy makers say these subsidies are temporary and will be withdrawn as the economy recovers. In our assessment, that’s the “exit strategy" option available for only one of at least three possible scenarios going forward

  • The goldilock scenario of a gradual recovery takes place and policy makers follow-through with monetary tightening, as well as fiscal discipline. Given that nothing has worked out exactly the way policy makers have wished or planned for, we doubt this scenario will pan out as anticipated.
  • The economy continues to run “below its long-run growth potential.” There is no exit for a long time. i.e. lots of money will be spent and printed, but it won’t have the desired effect policy makers are hoping for. It may be hazardous to investors’ wealth to think this path won’t be hazardous to the U.S. dollar.
  • The markets may force an end to excessive monetary and fiscal stimuli. Should the Fed try to fight higher rates through quantitative easing, market forces may overwhelm the Fed (should markets lose confidence, there is only so much even a central bank can do).

Europe is a prime example of a scenario in which market forces may prevail. We have seen what it means when the markets dictate the terms. The good news is that the sense of urgency has motivated European policy makers to engage in real reforms. By all means, the reforms are not perfect and may not be fully implemented, but major progress has been made in addressing structural deficits and fiscal coordination, key contention points of eurozone critics. Further, the European Central Bank (ECB) has not just talked the talk, but walked the walk: the ECB has embarked on an exit strategy; earlier this month €244 billion ($317.2 billion at $1.30 per euro) in liquidity was withdrawn (see our analysis).

Note that real reforms may have a real impact. Key reforms in Canada got the country on the right track in the ‘90s. Switzerland, too, which was veering off the path of fiscal discipline in the ‘90s, came to its senses last decade (some of which is currently undermined; c.f. Switzerland Under Siege). Finland, these days quoted as the poster child with regard to fiscal discipline in the eurozone, underwent soaring unemployment and a banking system collapse in the early ‘90s; the Eastern Bloc, where Finland derived much of its trade from in those days, exacerbated the negative implications of a housing bust.

At this stage, the market is giving the U.S. the benefit of the doubt. But it won’t be pretty if we wait until the markets dictate the terms. Of grave concern is that there appears little evidence of a concerted effort by policy makers to tackle the massive structural deficits facing the U.S. In our opinion, policy makers must not rest on their laurels, assuming the global market won’t ever bring the U.S. to account. Eventually this may very well happen. Look at the housing bubble or the tech bubble – it’s difficult to assess when these rides will be over; what is certain is that investors can try to take precautions now to take scenarios into account that veer off the goldilocks path.

We extensively discuss implications of these policies for consumers, businesses and investors; read the Merk Insights and subscribe to our newsletter. Please also join us for a webinar this Thursday July 29, 2010, where we provide an update on implications of the European stress tests, the economy and currencies; click here for information and to register.

We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. This analysis is a preview of our annual letter to investors; to learn more about the Funds, please visit www.merkfunds.com.

By Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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