Currency investing (1) - decline of the US$

One of the recurring themes in my monthly reviews has been the effect of changes in foreign exchange rates on my investment returns. With the Hong Kong dollar pegged to the US dollar, every dollar I have invested outside Hong Kong has benefited from the prolonged decline in the US currency. My net worth has been materially enhanced as a result (at least in Hong Kong dollars - like Flexo at Consumerism Commentary I have to query the extent to which the local currency gains in my portfolio are accurate reflections of real gains given the decline in value of that currency). The decline in the US$ has benefited me in other ways as well (higher income, lower interest costs etc) and hurt me in others (higher prices for most of the goods and services that I consume). On a net basis, the decline in the US$ has been a clear winner for me.

I can take very little credit for reaping the benefits of the US$'s decline. The extent to which my portfolio has benefited from currency movements has been largely a matter of historic accident and historic and on-going asset allocation decisions made with little regard for possible future currency movements.

The question I have been asking myself for some time is whether I should consciously allocate more of my investments to currency plays. As things stand, I would be betting on the US$ continuing to decline. A search on the internet failed to turn up any forecasts favourable to the US$ at all. That in itself makes me wonder how close to bottom the US$ is? Of course, I have no idea but it is very hard to make a bullish case for the US$. There are concerns that the US is heading into recession (or may even be there already). The US is expected to cut interest rates still further. Sub-prime related losses are still showing no signs of going away. The housing market in parts of the country is still in decline. Non-financial companies are showing signs of profit margins being squeezed by higher input costs. The almighty US consumer is widely believed to be spending less. The debt and the twin deficits continue to grow into unimaginable numbers. The list of negatives goes on.

The positives are harder to find. US corporates are becoming more competitive as a result of the weaker dollar. Lower interest rates and government bailouts are reducing the impact of the sub-prime and housing related problems. The complete absence of positive views on the US$. That in itself may be indicative of all the bad news and bad expectations already being priced into the currency.

The two uncertain factors (which could be either bullish or bearish) are foreign exchange reserves held by overseas countries and the fact that few countries wish to see their currencies appreciate too rapidly. With the US$ still the world's reserve currency of choice, it remains to be seen whether countries which are still accumulating foreign exchange reserves will continue to buy US$ as in the past or whether they will invest elsewhere. I suspect the answer is not whether they will invest outside the US but the extent to which they will diversify their holdings. (This already happening but has attracted surprisingly little recent commentary in the media.) As to countries preferring to keep their own currencies weak, there are signs that governments of at least some countries may allow their currencies to appreciate as a means of combating inflation.

It would take a braver man than me to bet against a continued decline in the US$ at this point. This leads on to the next question - if I assume that the US$ will continue to weaken, where should I invest my money?