Saturday, December 17, 2005

Bet Against the Dollar for 2006

Over the past two years Warren Buffet has lost considerable income betting against the dollar. Mr. Buffet took short positions against the dollar during this period of time accruing significant losses for his firm, Berkshire Hathaway. What accounts for Mr. Buffet’s miscalculation?

During this period of time, the U.S. trade deficit boomed to record levels putting downward pressure on the dollar. Thus those investors focusing on the trade deficit alone predicted the dollar would decline significantly against a basket of trade-weighted currencies. However, there were three other factors that overwhelmed the importance of the trade deficit.

First, countries such as China that accrued dollars as a result of the trade deficit invested the dollars in the U.S. bond market instead of converting the dollars to the home currency, the Yuan, or to competing currencies such as the Euro. Second as a result of changing tax laws, U.S. corporations, doing business abroad, were encouraged to repatriate their overseas earnings. This had the impact of increasing demand for the dollar thus increasing its relative value, especially against the Euro. Third, the Federal Reserve raised short term interest rates by 3.25 percent again placing upward pressures on the dollar as investors demanded more dollars to invest in the U.S. bond market. These three occurrences overwhelmed the negative impacts of a record trade deficit for 2005 increasing demand for the dollar pushing the dollar higher against most currencies, especially the Euro.

So why am I betting against the dollar for 2006? For one thing, the U.S. trade deficit is likely to continue at an unacceptably high level due to high oil prices. For another, the European Central Bank has indicated that they intend to raise short-term interest rates in the months ahead while the U.S. Federal Reserve will likely cease rate hikes after their January 31, 2006 meeting. Finally the wave of earnings repatriation for U.S. firms will wane in 2006 and the Chinese have indicated that they will allow the Yuan to appreciate against the dollar. As a result, I recommend that investors short the dollar at least the first half of 2006. This is not going to be a good year for the dollar.

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