That’s because of the historical tendency of the U.S.-Canadian dollar exchange rate, which is to move between $0.70 (U.S.) and $1.05 (U.S.). When an investor buys near, or at, the historical upper boundary, the loonie will in all probability be trending back down sometime within the next few years. The flip side of this move, of course, is an upward trend in the U.S. dollar, i.e. U.S. assets held by Canadians will be basking in the glow of currency gains.

In addition to this historical tendency, there are several other factors to suggest putting more eggs in the U.S. basket as the loonie moves closer to its upper boundary:

• The loonie is presently overvalued by 20% according to the purchasing power parity doctrine

• Loonie strength has been fuelled by signs of a greater recovery in the Canadian economy but the soaring loonie is offsetting policy stimulus while the falling U.S. dollar is adding to U.S. stimulus — so relative growth rates should shift over time in favor of the U.S. and support the its currency

• The Bank of Canada hasn’t intervened in foreign exchange markets since 1998 but it and the federal government have been jawboning about the hazards of a high loonie for months, so the hands off policy on currency intervention could be reversed at some point, especially if the loonie surges past parity

• Unlike other past run-ups in the loonie, this one is occurring with a deficit in the trade balance and while inflation is diving below the Bank of Canada’s target rate, further suggesting that currency intervention could be applied to stop the loonie’s rise

• Intervention by the Bank of Canada can be carried out almost without limit since there are no operational constraints on printing domestic currency and buying up U.S. currency and government bonds (China has been doing this for years); this would definitely be a possibility should the economy begin to wilt under the weight of the loonie’s rise

This rising bearish sentiment is at odds with a suggestion I made several days ago that “the U.S. dollar could rise as the fiscal deficit widens and pushes up interest rates.” Perhaps I should explain some of the reasoning behind this statement.

While the huge government deficits planned for the next few years will put pressure on the Fed to print a great deal of money to buy government debt and contribute to further debasement of the currency, it will also put upward pressure on U.S. long-term interest rates. And this rise in interest rates will attract inflows of foreign capital that should put upward pressures on the U.S. dollar.

The precedent is the period from the early 1980s when President Reagan and Congress ran an enormous deficit that resulted in a flood of government treasuries being issued. Successively higher yields had to be offered in order to get investors to take up the Treasuries. Those higher interest rates attracted large inflows of foreign capital, which bid up the value of the U.S. dollar — until the Plaza Accord of 1985 reversed the uptrend.

At the moment, the currency market seems to be betting that the Fed will choose to finance a big chunk of the deficit by printing money rather than letting treasury yields rise. That might be a reasonable assumption this early in the recovery, which is still in the “green shoots” stage. Moreover, the Fed likely feels it can run the printing presses without trigging inflation as long as amount of slack in the economy is as huge as it is presently.

However, as the recovery becomes more firmly rooted, I believe the Fed will step back and let treasury yields rise, shifting more of the burden of deficit financing to domestic and foreign savings. In fact, this will be necessary to cut the risk of igniting galloping inflation. In any event, rising bond yields should draw in foreign capital and boost the U.S. dollar.

If this scenario is the one that unfolds, it may be worthwhile over the next few months to pick up some units in currency ETFs on any further dips in the U.S. dollar. Canadian investors not fearful of double-leveraged ETFs could consider the Horizons BetaPro U.S. Dollar Bull Plus ETF (HDU). In the U.S., there are a lot of choices, including PowerShares DB US Dollar Index Bullish Fund (UUP).

It also seems worthwhile to continue holding the inverse bond ETFs suggested in the April 22 post, such as the ProShares Ultra-Short 20+ year Treasury (TBT). One ETF I didn’t mention, but perhaps could have for Canadian investors, is the Horizons BetaPro U.S. 30-year Bear Plus ETF (HTD).  The ETFs are up 10% to 20% since the post appeared. They might suffer a setback near term if the Fed moves to buy down treasury yields, but I would see such a reversal as more as a chance to add to (or start) positions.

A number of empirical studies have looked at this issue. From their backtests of hedged/unhedged globally diversified portfolios, they have found that hedging was unnecessary for long-term investors. Two examples of the studies, covering the 1975 to 2003 period, are the Thomas paper, ‘Currency Risks in International Equity Portfolios’ and the Statman and Fisher paper, ‘Hedging Currencies with Hindsight and Regret.’

If currency hedging is unnecessary for long-term investors, that would seem to be good news. It would spare them the costs of hedging. And this cost can be noteworthy for those people buying foreign exchange-traded funds (ETFs) that include currency hedging. Costs take the form of higher MERs and tracking errors.

Yet, one risk with the unhedged view is the “fat tail.” Most of the time, as recent history points out, currencies will tend to fluctuate in ways that average out. But once in a while, a currency may collapse or go into a long-term decline against others. Latin American currencies suffered this fate in the past.

The U.S. dollar may well avoid such a fate given its central role in the world economy. But many articles and books nonetheless have been written warning that accumulating financial and trade imbalances could some day result in a currency crisis or flight from the U.S. dollar.

U.S. investors in foreign assets would thus seem to have even less need to hedge than what the empirical studies suggest – at least if they are long-term investors. True, the U.S. dollar could rise as the fiscal deficit widens and pushes up interest rates. This is what happened under Reaganomics in the 1980s. But that appreciation lasted only a few years.

Foreign investors in U.S. assets may see currency hedging as worthwhile – especially if they have a high level of risk aversion based on “fat tail” outcomes. They may end up with a lower net return than an unhedged investor if the fat tail does not occur, but that would be acceptable as the premium on an insurance policy. Investing choices should, after all, be made on a risk-adjusted basis. Currency hedgers may want, however, to find the lowest cost way of hedging as opposed to convenient choices such as currency-hedged ETFs.

Meanwhile, as the Financial Times of London reports, jewelry demand, comprising about 70% of gold end use, is tumbling. High prices and slowing economies are causing jewelry buyers to cut back. Also, scrap supplies are surging in response to higher prices.

Gold bugs anticipate galloping inflation from monetarization of the government’s debt load, which is to be substantially increased by the requirement to rescue the financial sector. Admittedly, it’s possible the Fed may resort to the printing press but the forces of de-leveraging are way out front now, spreading ever stronger deflationary impulses. Expansion in the money supply won’t accelerate inflation when the economy is moving away from full employment.

Gold bugs anticipate a tumble in the U.S. dollar. Yet, government borrowing is destined to escalate because, as mentioned, of the imperative to rescue the financial sector; the higher borrowing in turn creates upward pressures on interest rates and, in turn, draws capital into the U.S. Besides, other currencies are not looking all that attractive either as the world economy sinks further into recession.

It could be a warning not to expect a sustained rally in stocks if and when policymakers stabilize the financial crisis. There may be no need to rush back into equities, just yet.

The silver lining might be that a weaker world economy could considerably reduce the odds of the tumble in the U.S. dollar, upward spike in interest rates, and/or galloping inflation that many fear will be the consequence of the U.S. government taking on an estimated $1 trillion (U.S.) in debt to rescue the U.S. financial sector.

As the Chinese economy ratchets down, the authorities will likely want to keep the yuan from rising even more so than before — so they should remain willing buyers of U.S. dollars and treasuries. They won’t want to flee U.S. assets when it will cause the U.S. dollar to fall against the yuan and undermine their export-led, industrial development strategy. A preliminary signal of their willingness to continue supporting the U.S. dollar was the recent decision to cut interest rates.

Commodity-based economies like Canada and Australia will see weakness in their currencies against the U.S. dollar as the commodity boom fades further. And Europe’s regional differences are likely to be exacerbated, raising political conflicts that could undermine the euro – on top of the region’s more restrictive monetary policy that seems destined to produce a greater and/or longer lasting economic slump in the region.

And don’t forget, the U.S. dollar’s status is not just about economics. For many countries, political considerations are paramount. Countries like Japan, South Korea, Taiwan and Saudi Arabia would not want to dump the U.S dollar and assets because of their security relationships with the U.S.

During recessions, lower risk appetite and flight to safety favors government bonds. Although the supply of treasuries will be rising in the U.S., so will portfolio demand – especially considering how underweight many investors are. A Merrill Lynch study noted households currently have less than 0.7% of their financial assets in government bonds, about $1 trillion (U.S.) less than the peak of 4% in 1993. Public pension bond holdings are close to two-decade lows. Bond yields are low right now, even negative after adjusting for inflation, but as the economy winds down, inflation should be subsiding.

Admittedly, the debt obligations arising from the financial crisis — along with ongoing debt requirements for other government programs — are substantial and there should be upward pressures on interest rates. However, like in the 1980s, higher rates should be bullish for the U.S. dollar as foreign capital flows in, attracted by the higher yields. And slack in the U.S. economy may also allow the Federal Reserve to buy some of the debt without inflationary consequences, which offers some assurance the rise in bond rates should not be extensive.

History is an imperfect guide, but when the Resolution Trust Corporation began to buy bad assets during the savings and loan crisis in 1989, U.S. economic growth, house prices and equity markets did not bottom out for another 12 to 18 months. The dollar, however, traded sideways during the period

There is some evidence it at least partly reflects hedge funds scrambling to raise cash to meet redemption requests. Financial stocks have risen for sure but that likely reflects hedge funds buying back short positions to generate cash, not to go long because they think the fundamentals are turning.

I remain somewhat skeptical of the thesis that the U.S. economy is close to coming out of the downturn, and so the places to shift into are U.S. stocks and the U.S. dollar. When one looks at the problems the U.S. has, especially in its financial sector, they would seem to have the potential to inflict more pain on the economy than we have seen to date.

Cash balances in hedge funds rose to a record $155 billion (U.S.) in July. A lot of this could be coming out of the market and going into investors’ hands. It may be erroneous to assume it will all be going into U.S. stocks.

1. Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Kevin Phillips
2. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis, Paul Muolo and Mathew Padilla
3. The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, Charles R. Morris
4. The New Paradigm for Financial Markets: The Credit Crash of 2008, George Soros
5. When Markets Collide, Mohamed El-Erian
6. Confessions of a Subprime Lender: An Insider’s Tale of Greed, Richard Bitner
7. Financial Shock: A 360º Look at the Subprime Mortgage Implosion, Mark Zandi
8. Financial Armageddon: Protecting Your Future (Revised and Updated Edition), Michael J. Panzner
9. Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve, William Fleckenstein and Fred Sheehan
10. The Coming Economic Collapse: How You Can Thrive When Oil Costs $200 a Barrel, Stephen Leeb and Glen Strathy
11. Buy Gold Now: How a Real Estate Bust, our Bulging National Debt Will Push Gold to Record Highs, S. McGuire
12. A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, Richard Bookstaber
13. The Collapse Of The Dollar And How To Profit From It, James Turk

But wait for it. When the dollar fell 30% in real terms from 1985 and 1991, the trade balance went from a deficit equal to 3.5% of GDP to approximately balance. This time around oil prices have climbed and masked some of the reduction. And most of the dollar depreciation since 2002 has come in the second half of the period (converse of earlier devaluation) — so much of the effect is still to be felt (given long lags of up to two years in the impact of exchange rate changes).

Extrapolating from the 1985 to 1991 experience, John Lipsky, First Deputy Managing Director of the International Monetary Fund (IMF), expects the U.S. trade deficit will decline in coming years to under 3% of GDP. For investors, this means a promising asset class going forward could be U.S exporters. As Lipsky said: “If the decline in the value of the dollar is supporting a narrowing of the … U.S. current account deficit, it is thereby helping to promote an inevitable shift in the sources of growth between tradable and non-tradable sectors in both surplus and deficit economies.”

At some point, China, India, and the other emerging countries with managed currencies will find their economies are getting too far out of line and may decide to give up their currency pegs. That means they will have less need to accumulate U.S. dollars. And lower demand for U.S. money could bring the world closer than ever to the long-feared run on the U.S. dollar. Similarly, there will be pressures on U.S. long-term interest rates to rise sharply since foreign countries will have relatively lower U.S. dollar reserves to plow into U.S. treasuries.

Things appear to be different from the 2001-2002 period. It is unlikely the same result — the mildest of recessions — will be the result. This time around the Fed has less freedom of action. The result will likely be a more substantial downturn. The stream of economic reports could be getting a lot uglier from here on in.