This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The dollar’s value against major currencies has fallen in recent months as the US fiscal outlook worsened and amid expectations that interest rates will remain close to zero for some time to fight the economic downturn.

This week, the euro broke above the psychologically important level of $1.50 driving gold prices to record levels, prompting many global central banks intervening on currency markets to slow the dollar’s fall (Fig 1).

How did we get here?

Since the financial crisis last fall, currency markets have taken their cues mostly from stock markets. When stocks plunged in March of this year, investors rushed to the safety of US government bonds, pushing the dollar index up to 89.62, the highest point this year.

Since then, however, it has been a steady downward drift for the greenback. As markets steadied into a rally, traders sold Treasuries and Dollars for riskier assets and higher returns, pushing the dollar lower against other major currencies.

The value of the euro has risen by 79% in nine years since euro hit 0.84 in Oct. 2000 (Fig. 2), and the White House has done little to curb the dollar’s slide during this period. Loose monetary policy and a weak US dollar are part of the consequences resulting from the US recent trends of unprecedented spending, fiscal deficits, and accumulations of government debt.

“Strong dollar policy” … not

Although the current Administration officially supports a strong dollar, the latest indications came from Federal Reserve Chairman Ben Bernanke and Larry Summers, President Obama’s chief economic advisor.

Mr. Bernanke said this week that the US should cut down on its budget deficit and increase the savings rate in order to reduce global imbalances. Bernanke’s statement chimed with that by Summers earlier this year, when Summers said that “the rebuilt American economy must be more export-oriented and less consumption-oriented… and less oriented to income growth that disproportionately favors a very small share of the population.”

World War III – currency

There are only so many paths you can take to be “more export-oriented“, and at the same time save more/spend less. We could increase our savings rate; however, with the unemployment rate around 10%, it is certainly a challenge, to say the least, for middle class Americans. Therefore, the most likely options are

1.     Devaluation of the dollar to help exports

2.     Slapping taxes on imports; or

3.     A national sales tax or a value-added tax (VAT), which seems to have gained traction in Washington, to discourage spending and fund federal deficits.

The problem is that much of the world is also working on increasing its exports to help recover from the global financial crisis. Many countries fear that strong domestic currencies (against the dollar) could harm their still fragile recoveries. A steep drop in the dollar has already enraged our chief creditors and trade partners resulting in Gulf States, Russia, and China reportedly ready to stop pricing oil and gas in dollars, and US clashes with EU and China on trade.

Tails, dollar loses

There have been increased signs recently that central banks and governments in many parts of the world may gradually end the massive quantitative easing programs. Australia, for instance, hiked rates to 3.25% and highlighting inflation concerns. The US Federal Reserve, on the other hand, has shown little indication that it is anywhere close to removing the massive liquidity injected into the system.

In fact, last Tuesday, San Francisco Federal Reserve President Janet Yellen said she doesn’t expect the central bank to tighten monetary policy “in the next few months.” This suggests the US will stay on its current course of stratospheric fiscal deficits, zero interest rates, easy money, and… a weak dollar in the near term. Worse yet, in a recovering world, any good news about growth could provoke dollar selling.

Double dip, hyperinflation or both?

A weaker dollar would be beneficial to exporters and to the balance of payments with a narrowing trade deficit as imports would fall faster than exports. So, with domestic demand depressed from the recession, a short to medium term boost to exports could be good for the US.

However, the flip side is that the diminishing purchasing power of the dollar will inevitably drive up prices for goods and services, among other long term effects. This could only result in three likely scenarios manifesting by the end of next year:

• W-shaped double dip recession as higher prices crimp recovery

• Hyperinflation, if we have a stronger than expected economic growth

• Another plausible scenario is that the US could lapse into a double-dip recession with high inflation in commodities, i.e., a stagflation scenario.

Based on the latest economic data and the near 50% one-year gain of the Goldman Sacks Commodity Index (blue line in Fig. 3), my money is on stagflation.

Dollar status intact, for now

The US remains the largest economy in the world. The absence of a credible alternative to the dollar, means that, despite its declining value, its status as the world’s reserve currency is not seriously under threat. In addition, the complexity, geopolitical realities would arguably rule out the re-pricing of oil in non-dollar currencies at this time. All that might change in the future, but it will be a very long, long (think decades) debate.

Strategy: Anti-dollar & anti-inflation

Meanwhile, the dollar will continue to weaken as interest rates in many countries and the eurozone are higher than the current rock-bottom US rates, providing currency traders carry-trade opportunities. This will encourage more selling of the dollar and buying up stocks, commodities and other currencies, which has been the general trend since spring.

So, based on the discussion so far, prudent investors should allocate a portion of their portfolios to hard assets like silver, agri products, and non-dollar currencies such as Brazil’s Real (BRL) or the Australian Dollar (AUD) to hedge against inflation risk and the US Dollar’s devaluation.

Source: Dian Chu, Economic Forecasts & Opinions, October 25, 2009.

*Dian Chu, Market analyst, trader and financial writer for Seeking Alpha, Zero Hedge, Daily Marksts, iStockAnalyst & StraightStocks. My articles also appear in Reuters, USA Today and BusinessWeek, etc. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. Previous employers include Enron, Time Warner & Clear Channel. I’m currently working in the US for the energy sector.

Click here to view her full profile.

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