As regards US foreign trade, the two major currencies concerning us are the Euro (now the official currency of the European Union) and the Japanese Yen. While other Asian economies are growing rapidly, such as India and China, their effect on the US and reciprocal trade are not yet nearly as significant as the yen. The weakening of the dollar is exciting news for US manufacturers, who are in line for a bonanza of foreign buying of US goods.

Generally, the dollar has been weakening against both the Euro and the yen (and most other major currencies) since mid-2002. Recently, the Euro hit an all-time high against the dollar; it took $1.29 to buy a single Euro. The yen has been showing similar strength. Other countries are taking steps to keep their currencies weak against the dollar. Why? Because if the dollar is allowed to continue to weaken against their own currencies, the foreign countries will see the US markets dry up for their exports as their goods become too expensive for Americans. The strong dollar through early 2002 resulted in a large trade gap, with the balance of trade against the US - that is, we were importing more than we exported, and that had been going on for years. So a weakening dollar is actually good news for US exporters, and will help us address the large trade deficit and improve our balance of trade. The dollar's weakening trend probably is not yet over. The tide ain't turned yet. Now let's look at what has caused the dollar to weaken.

Interest Rates vs. Inflation

So why does the dollar strengthen or weaken? The answer lies in the interaction of the rate of inflation compared to the Fed Funds rate - the interest rate at which US banks lend to each other overnight. The Fed Funds rate is actually a target rate, and actual interbank loan rates can vary somewhat, but this rate is the fundamental benchmark rate in the US banking system. In mid-2002 the rate of inflation in the US spiked high against the Fed Funds rate. That is, the dollar is weak against other currencies because dollar inflation is outstripping US interest rates.

But this just begs the next question - what does inflation have to do with the strength of the dollar? Keep in mind that at the end of the day, currencies are just another traded commodity. Currency traders are happy to buy or sell dollars, as their financial interests dictate. They (even US traders) have no loyalty to any currency. The dollar is a commodity, remember? Traders speculate in it the same as daytraders trade stocks.

Inflation and Devaluation of the Dollar

The primary way that the US borrows money is by issuing Treasuries, which are simply loans by investors to Uncle Sam. Cut it how you will, though, Treasury buyers are buying dollars. When inflation is low against the dollar, the dollar is an attractive holding, because it produces net cash flow to investors. And no currency is more stable or solid than the dollar. But when dollar inflation occurs, the devalued dollar cuts the yield from owning dollars. When dollar inflation actually outstrips interest rates, which is the state of affairs now, the dollar becomes devalued and is worth increasingly less. If inflation devalues the dollar at a faster rate than interest accrues on those dollars, it actually begins to cost investors money to hold dollars. Then investors flee from dollars.

That is precisely what is happening now. While lowering the Fed Funds rate to its all-time low was necessary to stimulate the US economy, a side effect was to lower it to the point that inflation was almost bound to leapfrog interest rates. While good for US exporters, the weak dollar also makes it more difficult for the US government to raise money, since no one particularly wants dollars. We have been strong-arming our rich friends (e.g., Saudis) to buy Treasuries, and even European countries, Japan and others have a vested interest in buying them. After all, to let the dollar weaken too much hurts their own economies when we start buying less of their goods. We're still the largest single-country market. But even to get friends and non-friends to buy Treasuries requires the US to really sweeten the deal, raising the interest rates paid.

The dollar will begin strengthening again when interest rates catch up to inflation, and the real dollar momentum will gather when inflation drops below the interest rate. This will also make it easy for the US government to finance the national debt, since people around the world (and here in the US) will be more willing to save dollars. In fact, there is almost no incentive for US citizens to park money in 2% bank accounts while inflation eats up all of their bank interest, and then some. The following table illustrates the facts of life when inflation rises above interest rates:

Effects of Inflation and Dollar Devaluation		Inflation eats up interest earnings, so Americans save less. They put their money into other investments (or just spend more). In fact, savings are dreadfully low.
		Foreign investors spurn dollars because inflation eats up their interest earnings just the same.
		It becomes harder and more expensive for the US government to borrow and keep refinancing the deficit.
		The deficit gets harder to pay down as interest costs keep mounting. In a few years, interest on borrowings will be a major part of the US government budget. This hurts all of us. I'm betting it is a huge issue in 2008.

Do we really care about the deficit?

Actually, yes we do. What follows is not a political rag by any means, but it is necessary to understand, since deficits are important. When George W. Bush took office, there was a surplus of approximately $500 Billion. There is now an $800 Billion deficit (due in large part to his tax cuts and Iraq war), which is a $1.3 Trillion swing in the wrong direction. While it has been worse in history, this deficit chokes our economy. We are drowning in debt, and this does not make it any easier to convince people to loan money to Uncle Sam. And the deficit is so huge, we can only keep the lights on and wheels turning by massive borrowings at accelerating interest rates.

If the dollar was weakening without the huge deficit overhanging the economy, getting an economic recovery would be easier. Whether you are a Republican or Democrat, the effect of the deficit is the same. The tax cuts did not stimulate the economy to nearly the degree predicted by the administration, although they did run the deficit up. I would hope in the future to see tax cuts that are more tied to productivity increases instead of just handouts - this would be a worthwhile tax cut.

So What's an Investor to Do?

Companies that rely heavily on exports can expect booming sales in the coming couple of years due to the weakened dollar. Expect them to put the peddle to the metal while they can. Manufacturers like Microsoft who have a low unit cost of manufacturing will especially benefit. Gold stocks also tend to do well in inflationary periods. Companies that import or that rely heavily on imported goods for manufacturing, on the other hand, will not do so well.

For covered call writers these concerns are not so important, since we are not investing long term in the stocks we buy, and we tend to hold stocks a month or less. But those selecting portfolio stocks for the intermediate or long term (even if principally to write calls against) definitely should pay attention to how the weakening dollar will impact the companies' earnings. On the other hand, covered call writers who tend to write further out in time (3 months out or more) should probably pay attention to each company's intermediate-term outlook. Those writing (or buying) LEAPS calls certainly should pay attention to the weakening dollar's impact. The CallWriter Research Page allows you to dig in for this kind of information.

So the weakening dollar, like I said in the beginning of this article, is not all bad. Wherever the economic wheel is in its cycle, somebody is getting ahead and others are not. I expect the weakening dollar to stimulate our economy and clean up our trade deficit. Whether this will lead to a stronger stock market remains to be seen, since the overhanging deficit will continue to exert a negative effect on the stock market. Without the huge deficit, the market would be poised to soar. On one thing we all can agree, the next four years will be interesting!