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Buy Non-Dollar Denominated Bonds

By Yiannis G. Mostrous on December 16, 2010

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The global economy should post respectable growth in 2011 and markets should also perform well, at least for the first half of the year. I also expect that emerging markets will outperform and their currencies should make gains against the euro and the greenback.

Emerging economies will be the engine of global economic growth. This growth, combined with easy monetary policies in developed countries, will increase outflows of money to emerging economies, particularly in Asia. Inflation will hold steady at elevated levels, resulting in higher currency prices.

I maintain the structurally bearish outlook on the US dollar that I’ve held since 2002. Although I don’t expect the dollar to collapse any time soon, and certainly not in 2011, hedging one’s portfolio with non-dollar denominated assets is still a prudent course of action.

Benjamin Shepherd, my co-editor at www.GlobalEtfProfits.com, recently wrote an interesting piece on this subject, and I encourage you to take a look. For more on how to enhance your portfolio’s performance with exchange-traded funds (ETF) click here.

A Decade of Decline

By Benjamin Shepherd

Ever since the 1944 Bretton Woods Conference, the US dollar has been the world’s de facto reserve currency. That unparalleled status gave our nation a leading role in global economic affairs after World War II. It also marginally reduced costs for the commodities we consumed, giving us an edge over the rest of the world in terms of input prices. That era is winding to an end.

The dollar’s dominance has slowly eroded over the past decade. The greenback accounts for 62.2 percent of global foreign exchange reserves today compared to more than 70 percent in 2000, according to data from the International Monetary Fund (IMF). Loose fiscal policy and a fondness for deficit spending have chipped away at the world’s confidence in the dollar. As a result, global central banks have been diversifying their reserve holdings to include greater portions of other global currencies such as the euro and precious metals such as gold.

This faltering confidence in the stability of the dollar has led to calls to scrap the greenback as the global reserve currency. China, a known currency manipulator, has advocated greater use of international reserve assets such as the IMF’s special drawing rights, which track a basket of currencies. A number of countries have said they will sidestep the US dollar by using their own currencies in international trade.

A strong case can be made that such a development wouldn’t be entirely negative. If the dollar sheds its reserve currency status, the cost of financing large external debts will necessarily rise. That will force the US government to rely more heavily on internal financing–for example by encouraging more Americans to purchase Treasury bonds–or rationalize spending programs that are disproportionate to revenues. Essentially, a more rational fiscal policy will be foisted upon the US.

Global governments may be paring back their exposure to the US dollar, but a sudden shift would have severe consequences for much of the world. Countries such as China may be saber rattling for a new currency of commerce, but drastic change is unlikely for now.

Although the greenback’s value has resurged during the global financial crisis, this second round of quantitative easing will surely help sustain a high deficit. Combined with a general decline in confidence in the dollar, the currency’s value will continue to fall.

My outlook on the dollar and the expectation that emerging markets will post stronger growth than what we see in the developed world, prompted me in April to recommend  iShares JPMorgan USD Emerging Market Bond Fund (NYSE: EMB) as a good way to hedge a long portfolio. Holding only US dollar-denominated bonds issued by foreign governments, the fund has returned almost 8 percent since recommendation without exposing the Portfolio to currency risk. Going forward though, currency exposure–specifically lower exposure to the US dollar–is exactly what we want.

Offering similar country and credit exposures as the iShares offering, Market Vectors Emerging Markets Local Currency Bond (NYSE: EMLC) purchases only non-dollar denominated bonds.

Over the past decade many governments in emerging markets have controlled spending, allowed their currencies to float more freely and strengthened ownership rights for their citizens. Most of these governments have also built strong balance sheets that have helped insulate them from the worst of the financial crisis. The currencies of these nations will perform strongly relative to the dollar, boosting the returns of emerging-market bonds. Consequently, we recommend you gain exposure to non-dollar denominated bonds.

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