Macro Tsimmis

intelligently hedged investment

BUY PowerShares DB US Dollar Bearish ETF (UDN)

Posted by intelledgement on Wed, 20 Oct 10

“Dollar devaluations will continue until purchasing power improves.”   —Tyler Durden

Well, in the sense that the dollar is down 40% since 1985, and down 20% since 2003, and down 10% since June, one could say we are late to this party. However, given the micro threat of QE2 layered on top of the macro trend of the weakening of fiat money since the end of Bretton Woods in 1971 (at least), we feel the need to take a position here, not so much seeking to profit from the fall of the dollar as merely insuring the value of our assets.

Governments have been debasing their currencies ever since (at least) a succession of Roman governments adulterated the denarius by decreasing it’s silver content. Of course nowadays, human technology has advanced to the point where the U.S. government can achieve the same end with the click of a mouse by some functionary, instantly creating gobs of dollars bearing no relation to silver or any real world commodity whatsoever. And our government has, in congruence with the prevailing Keynesian cant, consistently “loosened” the money supply—created gobs of new dollars—to “stimulate” the economy whenever growth slowed down to the point where job creation was failing to keep pace with population growth. They have also slowed down the growth of the money supply when inflation got too high…but somehow, the tightening has, over time, failed to balance out the loosening. Consequently as the increase in the supply of dollars has, over time, outstripped the growth in the goods and services to spend them on—not to mention outstripping the growth in the number of spenders—the value of the dollar over time has declined.

This imbalance has occurred, in our opinion, because attempting to “manage” the ups and downs of the economy is a fool’s game. Artificial fiat-created incentives fosters malinvestment, distorting valuations and inevitably leading to unnaturally large bubbles. In essence—as we have said before—it is akin to fighting an oscillating skid. The proper way to react to a skid is to turn into it to reestablish control, not to fight it, which only makes it more likely you will crash.

Economists have been arguing about this for decades. But regardless of whether one favors Keynes or Hayak, the existence of the imbalance—in the sense that overall, the dollar has lost more value than it has gained—is inarguable, as you can see in this chart showing the value of the dollar for the last 25 years:

U.S. Dollar, October 1985-October 2010

Unfortunately, the bias towards inflation is reinforced when the government falls into debt itself. This is because if the government is unable to collect enough revenues to pay the interest and principal due on bonds as well as maintain their other expenditures, the temptation grows to simply print (or electronically create) more dollars to make up the shortfall. We are clearly moving in that direction here…and then there is the proximate imperative for more quantitative easing—in this case, using the funny money to purchase bonds—to “stimulate” inflation or job growth (or whatever). We know the effect will be to inflate/devalue the dollar; we fear the (likely) risk of stoking a currency war, or even the (less likely but possible) risk of igniting runaway hyperinflation.

Our choice to protect ourselves against devaluation is the PowerShares DB US Dollar Bearish Fund (UDN). This ETF is based on the Deutsche Bank Short US Dollar Index (USDX®) Futures Index™ (DB Short USD Futures Index). The Index, which is managed by DB Commodity Services LLC, is a rules-based index composed solely of short USDX® futures contracts. The USDX® futures contract is designed to replicate the performance of being short the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc.

UDN has a twin brother, the PowerShares DB US Dollar Bullish Fund (UUP, of course). Both funds opened for business in February 2002. Since then, the U.S. dollar index is -9%, while the UDN is +11% (two percent better than expected) and the UUP is -11% (two percent worse than expected). This gives the UDN an Intelledgement ETF Rating (IER) of +5 (meaning on a compounded annual growth rate basis, it is about 5% ahead of where we should expect it to be). So no problem there. Here is a chart showing the performance of both ETFs as well as the dollar index:

UDN & UUP vs. the dollar index, Feb 02 to Oct 10


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