(ETF) Why It’s “Mayday” For the Euro And What You Should Do

March 8th, 2010

I’ve often said that it’s not possible to predict stock markets, commodity markets, bond markets or currency markets consistently and accurately.

But there is an exception: when both valuations and sentiment reach severe extremes simultaneously.

That’s what happened with the dollar a few months ago. And, seeing the planets in alignment (as I’ll explain), I immediately wrote a column, predicting that the greenback would soar in the months ahead.

As is the case with most contrarian calls, my message was met with immediate catcalls and derision from respondents. Readers e-mailed me that a weaker dollar was a “no-brainer.” With the size of our budget and trade deficits and nearly $60 trillion in unfunded liabilities, they insisted, the U.S. currency had nowhere to go but down.

But, oh, how times have changed…

Less than three months later, the euro has plunged 10% against the dollar. And it will almost certainly fall further.

The Euro Plunges Against the Dollar

Fortunately, there is plenty you can do to protect yourself – and profit. Here’s how…

Spanish Decisions… Made in Germany

Anyone taking even a sidelong glance at the news knows that huge budget problems in Greece are undermining the euro. In response, Athens is proposing serious austerity measures to shore up the country’s finances.

But this is just a finger in the dike. There are other leaks in the euro that are ready to spring in Portugal, Italy, Ireland and, especially, Spain.

Imagine for a moment that you’re a Spaniard:

Your country has a 19% unemployment rate,
A deflating housing bubble,
Enormous debts
And a gaping budget deficit.

Your economy contracted 3.6% last year and is likely to shrink again this year, leaving Spain in its deepest and longest recession in more than 50 years.

But there’s a bigger problem…

Because Spain is a member of the 16-nation eurozone, it can’t devalue its currency to make its exports more attractive, or its sunny beach resorts cheaper. Why? Because the euro’s value is driven by Germany’s bigger, more competitive industrial economy.

Furthermore, Madrid can’t slash interest rates or print money to spur borrowing or spending, because the European Central Bank now makes those decisions in Frankfurt.

In other words, “Goodbye, Spanish autonomy… hello, recession.” And “Tim-ber!” for the euro, which is vulnerable, overvalued and is now enduring concentrated attacks from hedgers, speculators and hedge funds.

The Eurozone’s Dangerous “One-Size-Fits-All” Policy

Don’t get me wrong. The euro isn’t going to collapse like the British pound did in 1992 when George Soros booked a $1 billion profit in one day by shorting the euro.

The euro is an extremely deep market, with over $1.2 trillion in daily trading volume, dwarfing the British pound’s daily volume in 1992.

But the euro has a major structural problem – one that investors were much more wary about when the currency made its debut 15 years ago. You have widely disparate European economies all tied to the same central bank policies. And now the cracks are beginning to show…

The eurozone economy will grow much more slowly than the U.S. economy this year. And Fed chairman Ben Bernanke is likely to start raising short-term interest rates sometime in the second half of the year.

(Bear in mind, the rate increase won’t be due to a substantial increase in inflation. That’s unlikely. Bernanke will raise rates to signal that the world economic crisis is abating and to put some arrows back in his quiver. After all, you can’t cut rates if they’re already at zero.)

And this move will be bullish for the U.S. dollar. So what should you do?

Three Moves to Combat a Strong Dollar-Weak Euro Scenario

As I’ve said for the past few months, here are three moves to combat a strong dollar-weak euro scenario…

Pare back on holdings of euro, pound and yen-denominated bank accounts and bonds. A stronger dollar will hurt these the most.
Maintain your exposure to European and other foreign equities. If you own the right stocks, especially exporters, their capital appreciation can outstrip a negative move in the local currency.
If you want to be even safer, there is one – and only one – exchange-traded fund (ETF) that hedges away all currency risk for dollar-based investors. It’s called the WisdomTree International Hedged Equity Fund (Nasdaq: HEDJ).

Expect to see it near the top of this year’s top-performing international exchange traded funds.

Good investing,

Alexander Green

View original at: Investment U

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