Economic Landscape

In our view, the policies and initiatives undertaken to combat instability in the markets, while well intentioned, will have significant unintended consequences, and may only serve to exacerbate dilemmas down the road. Prior steps taken by policy makers and central banks seem to have, by and large, succeeded in stabilizing financial institutions and avoiding a disorderly collapse in markets around the globe. That said, we take great issue with the continued level of intervention in the markets.

We consider the Fed’s decision to purchase agency mortgage-backed securities (MBS) not only creates significant latent inflationary pressure (the size of the program dwarfs the total size of the Fed’s balance sheet before the crisis began), but also inherently creates an unprecedented level of inflexibility at the Fed. Should inflationary expectations rise, we are concerned that the very purchase of MBS assets may render the Fed incapacitated in addressing such a situation. MBS assets are relatively illiquid and much longer-term, hence the Fed may find it increasingly difficult to unwind the positions it is presently building to counteract inflation, should inflationary expectations flare up (see also: Why does the Fed's balance sheet matter to me?).

Another consequence of the Fed buying Treasury Bonds and agency securities is that the prices of these securities, in our opinion, no longer reflect free market dynamics. As a result, rational buyers may consider these securities overvalued and reduce their appetite to buy them. If foreign buying is reduced as a result of the Fed’s interference in the markets, it may have negative implications for the U.S. dollar. U.S. based investors may also increasingly seek to protect against U.S. dollar currency risk. If U.S. investors progressively move assets abroad, that may also have negative implications for the U.S. dollar.

In addition to our concerns over market interventions, the nation's financial imbalances—as evidenced by the U.S. current account (trade) and budget deficits — remain at unsustainable levels.

The current account deficit is the difference between what Americans earn from other countries (exports, services, investments abroad) and what we pay out to other countries (imports, services, loans). This shortfall - the combined balance on trade in goods and services, income, and net unilateral current transfers - between the U.S. and the rest of the world amounted to $673.3 billion in 2008.* As a share of gross domestic product (GDP), the deficit amounted to 4.7% in 2008. To put this in perspective, foreigners must absorb this shortfall by buying about $2 billion worth of U.S. dollar denominated assets every single day, just to keep the dollar from falling. If the U.S. borrows as much as anticipated by economists, the current account deficit may surge in 2009.

(Source: Bureau of Economic Analysis news release March 18, 2009.)

Yet another big weight on the dollar is the large (and increasing) U.S. budget deficit. With the unprecedented level of government spending, we are set to witness the largest budget deficit in history. Not only do we harbor concerns over the funding of short-term government obligations, but it is not yet clear how the U.S. will pay for its long term obligations, including Social Security, Medicare and Medicaid.

While we cannot predict with certainty that the dollar will in fact decline, you may want to assess the above overview of economic forces in determining whether a basket of currencies is a valuable diversification element in your portfolio with an objective that seeks to protect against a further decline in the dollar.

• Why does the Fed's balance sheet matter to me?
• Why does the value of the U.S. Dollar matter to me?
• What has caused the U.S. Dollar to fall?
• Will the U.S. Dollar continue to fall?
• How can I protect myself from a falling U.S. Dollar?

*Source: Bureau of Economic Analysis news release March 18, 2009.