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Merk: Don't Fight the Fed

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

The dollar has been popping up in a lot of market headlines recently, especially in light of the Fed's recent policy action. But what does this currency news mean for investors? I'm joined today with Axel Merk of Merk Mutual Funds and also a currency expert. He is here to offer his insights on the situation.

Thanks, for calling in today, Axel.

Axel Merk: My pleasure.

Stipp: First question for you: The Fed, obviously, had its reasons for the additional $600 billion of stimulus. You wrote in a report recently that there is likely to be several unintended consequences from the Fed's actions. Can you outline some of those effects and what they may mean?

Merk: Yes, by all means, and maybe they're not even unintended. We believe that the Federal Reserve may be squarely targeting a debasement of the U.S. dollar. Fed Chairman Bernanke has talked about how going off the gold standard during the Great Depression has helped the U.S. recover from the Great Depression. He has said that a weaker dollar is not inflationary. We disagree with that, but that's his view. Then he is putting actions into his words by buying government bonds. These securities are now intentionally overvalued, rational investors may look overseas for less manipulated returns. And so that's the premise that we have, that he may be acting to get a weaker dollar.

Now, the unintended consequence, maybe, is that Bernanke is completely underestimating the political dimension. The fallout that we have--particularly overseas fallout. Let's remember that during the Great Depression, what got the Great Depression really to be so horrible was the trade war that started, protectionism flared up, all unintended consequences of well-intended policies that served the home market, but completely underestimating the global implications of these policies.

Stipp: Certainly we've seen a lot of headlines since that policy announcement, reactions from different world leaders. It sounds like you think that's more than just talk, that we could see some actual policy responses from the international community that could lead to some problems on the trade front?

Merk: Well, let's keep two things in mind. Every country, the U.S., China, anybody will always do what they perceive to be in their national interest. I say perceive because sometimes they don't know what's in their own good. And the other thing we do know is that many parts of the world, including much of Asia, has imported U.S. monetary policy by pegging their currency to the U.S. dollar.

So, when the Federal Reserve debases or tries to debase the dollar by engaging in quantitative easing, it's as if the Federal Reserve puts a gun on the chest of China to say, now you've got to act. You need to allow their currency to appreciate. The reason why China needs to do that is because inflationary pressures cannot be controlled using administrative tools. We've seen it with the most recent news come out yet again, when inflation is flaring up in China that most effective way for Asian countries to tame those pressures is by allowing the currency to appreciate.

And these countries don't like it because they are uncomfortable with it. Now, what we're arguing is that the countries that have more advanced economies, such as China or even the Eurozone going in this direction, they have pricing power. At the other end of the spectrum, countries like Vietnam that can't compete on price, they will engage in competitive devaluation. But for the time being, there is a lot of anger out there in the world because the U.S. conducts these things unilaterally, and of course, they do because they act in their own self-interest, but the communication the U.S. has done to encourage other folks to cooperate with the U.S. has not been very effective.

Stipp: So Axel, as an investor, and looking at the fundamentals of currencies, what do you think the impact then is going to be longer term for currencies? And which currencies do you expect to move over the longer term because of some of these factors that are coming into the marketplace in the U.S. policy?

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Merk: Well, there are many dimensions to that. The first one may be that policymakers are ever more engaged in the markets, which means asset classes are moving more and more in tandem. And that means that there is very few places to hide when there is a flight to quality, and currencies allow investors to manage those interventions and to find and design portfolios that have a low correlation to other assets.

The second one is: don't fight the Fed. If the Fed wants to have a weaker dollar, well, do what central banks do, diversify to a basket of currencies or manage basket of currencies. As I indicated, we believe that the stronger countries have the most pricing power. So in the Eurozone, it's not as easy to print and spend money as in the U.S. As a result, we believe the euro may be stronger.

China had pricing power. When China raises prices, there is nothing we can do about it. The weaker Asian countries may engage in competitive devaluation. What we have to watch very closely is how vigorously these countries will fight the moves in the U.S. We see Brazil, for example, imposing trade barriers. At the other end of the spectrum, we have Sweden, New Zealand, and Australia that have all come out publicly against currency intervention, against putting up trade barriers.

So you may want to move your money to countries that are more open and more advanced in order to fend off the move by the Federal Reserve that is a desperate attempt, in our view, to try to jumpstart economic growth by debasing the dollar.

Stipp: Last question for you, a lot of investors are thinking about this in terms of a broader portfolio; they may already have international holdings. What would you say to an investor who already has a diversified portfolio but is interested in making sure that the portfolio is at least sensitive to some of these fundamental factors? What adjustments might they need to make or might they consider making in light of the situations that you've just described?

Merk: Yes, there are two main ways to look at currencies. One is the directional currency play, selling the dollar, buying a basket or managed basket of currencies--that over the medium term has a very low correlation to anything else investors may be holding, and can also be considered a special case of international bond investing, where one tries to minimize interest rate and credit risk.

Or one takes currency investing all the way to a non-directional play, where one goes long and short, otherwise highly correlated currencies and through that creates a portfolio that almost certainly will have a low correlation or no correlation to anything else investors may be doing. And what that means is, say, for example, you are taking a position of the Swiss franc versus the euro or a New Zealand dollar versus the Australian dollar--while you can't guarantee to make money with such a trade, what you are reasonably assured of is that the returns generated by that have an almost zero correlation to anything else that you will be holding. On top of that, you are dealing in a most liquid asset class.

People always think that currencies are speculative, but if you don't use leverage, currencies are actually less speculative than other asset classes. And so we publish a lot of white papers trying to discuss those dynamics. We encourage anybody to have a look at those. Get to know the currency asset class. In an environment where policymakers are ever more engaged, currencies may offer ways to diversify a portfolio that is not available through the additional asset classes.

Stipp: Axel Merk of Merk Mutual Funds, thanks so much for joining us today and for your insights on the currency market.

Merk: My pleasure.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.