Last week we profiled the recent declines in the value of the dollar…and why we believe this is a trend that will continue.
That was 14 days ago, and already the USD Index is down another 4.2%—we’ll say it again:
These declines will beget more declines; The world’s reserve currency has a lot further to fall.
For more background and to understand the underlying forces at play, take a look at our last article “The Dollar is Down Over 10%, What happens next?” if you haven’t already.
With the trend now identified, the larger point as an investor becomes what to do about it.
We’re going to cover two very simple plays—plays that we have in place ourselves– to profit from a continuing decline in the dollar. And while the bets themselves are rudimentary, understanding the context is crucial, especially if you’re new to the currency game:
Normally, we use currency as a tool to measure or establish the value or worth of a product or service. That boat is worth X dollars, those tickets cost X amount, etc.
But when you start asking how much that dollar itself is worth, it can get a bit Zen.
Because we can assign a value to any product in terms of dollars—we’re using dollars as a means of measurement—pretty simple.
But how can you measure the means of measurement itself? How do we measure an inch, if not in inches? What is an inch if not….an inch?
An inch has always been, and will always be, an inch in length…right?
Well, as long as we’re talking about inches—about distance—yes.
Because it is fixed. It is a fixed and constant value. And it used to be like this with the dollar: the dollar was fixed to a certain amount of gold. X amount of dollars equaled X amount of gold.
And, because the Dollar had a constant, known value, the other nations of the world didn’t bother fixing their currency to gold, they just fixed their currency to the Dollar, which was itself fixed to gold. And all was well.
But, in 1971, the US abandoned this practice, abandoned a fixed ratio of dollars to gold. Our currency became what’s referred to as “free floating.” And by extension, any currency fixed to the dollar—all of them in this case– necessarily became “free floating” as well.
A free-floating dollar means that instead of having an established, fixed rate of exchange (with gold or other currencies), it’s value fluctuates based on supply and demand of the dollar in comparison to supply and demand of other currencies.
In other words, in today’s world currencies trade relative to one another—instead of using gold as a fixed unit of measurement, the value of a dollar today is measured in how many yen or euros or rand it takes to buy a dollar, and vice versa. The value of all currencies is in a constant state of flux, with currencies using each other as a unit of measurement in establishing a value or price.
Ironically enough, the inch met with a similar fate.
While in everyday practice we use an inch as though it is a constant, fixed distance, we now know that inches can grow or shrink. It turns out length itself is relative–relative to gravity or acceleration—a phenomenon called length dilation.
Unfortunately, none of the Fat Cats we invest with have found a means to successfully monetize length dilation. Or gravity for that matter. So back to the dollar.
Because currencies trade relative to one another, when one currency is strong, there must be another currency that is weak somewhere else.
And while initially that may sound like one hand clapping, it makes perfect sense when you analyze each part of the process through the lens of our old friends supply and demand.
Let’s say my buddy Scotty out on the west coast concludes that the Japanese Yen is going to go up in value (relative to the dollar).
Speculating, Scotty exchanges his US Dollars into Yen.
Economic law tells us that when someone sells something, the supply of that something increases. Likewise, the act of buying something, by definition, equates to an increase in the demand for that product.
So, what Scotty is really doing is selling his Dollars and buying Yen in return; his act of selling his dollars increases the overall supply of US Dollars, and by buying Yen he has increased the overall demand for Yen.
Now suppose that a big chunk of the west coast decides that Scotty, being the charming lad he is, is bound to be on the winning side of this bet; they all follow suit and rush to make exactly the same trade.
The result? A huge supply of dollars sells into the market – pushing the value down—while an equally huge buying spree of yen increases the overall demand for Yen – pushing the value up.
This see-saw relationship is what makes currencies so interesting, and it’s even more prominent charted.
Let’s look at the relationship between the USD and the EURO over the last
Notice how the EURO has dropped in value by over 27% during the time the USD rose almost 30%.
And we see an inverse relationship again when we look at the British Pound Sterling (GBP) – it fell 28% in the same time period.
Granted, there are many other currencies, and there are other factors in play that can affect the price point of currencies.
But, considering the period of time this relationship has been observable, and considering the frequency and quantity of times we’ve charted this relationship, we’re confident this strong inverse correlation will continue forward for a reasonable period of time.
And now we can make money.
If we believe the dollar will continue to fall, and we believe that the relation of the pound and the euro to the dollar should continue, then it follows that
The Euro and the British Pound will rise.
After all, as investors sell their dollars into the currency markets, by definition they are buying other currencies, thereby increasing demand and upwards price pressure. So the dollar’s decline in and of itself is bullish for the other major commodities.
And following this rich, dynamic collection of relationships which form our background, the actual trade itself is equally extreme in its simplicity: a chip on the Euro and another on the pound.
- The Euro Trust (Ticker: FXE) – which basically tracks the Euro’s value.
- The Pound Sterling Trust (Ticker: FXB) – same for the British Pound.
And while everyone else plugs into the tube and bemoans the dollar’s decline, so shall your stack grow tall and prosper.
Because a Fat Cat Investor make money on the way up AND on the way down.
If that appeals to your inner Fat Cat, enter your email above and join our club.
Christoph Grizzard, The Fat Cat Investor
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