Why the dollar keeps dropping

By Jim Jubak

The dollar hasn't been this low in a decade, but it's headed lower. By the end of 2007, we can expect the dollar to buy 11.6% less versus the euro than it did at the beginning of the year.

As the dollar continues its slide, count on Wall Street to gear up its fear machine.

Any further retreat in the dollar will put the U.S. currency on the edge of unexplored territory. The fall of the U.S. dollar into unknown territory, the argument is likely to go, would break the will of those overseas central banks, from Russia to Saudi Arabia to China, that have been buying dollars to give their countries' exports a competitive edge.

Well, I'm sorry, but I just don't buy that scenario. Wall Street could, of course, scare itself into a dollar rout because many of the folks who work there are so traumatized by the crises in the markets for mortgages and for buyout loans that they're likely to jump at shadows, even when the shadows are of their own making.

Look to overseas markets

I think it's much more likely that we'll continue to see a steady decline in the dollar, punctuated by rallies as traders take profits. The Federal Reserve, which rode to the rescue in the August crisis, can't do much this go-round. Cutting interest rates to save economic growth hurts the dollar. Raising interest rates to help the dollar would hurt the economy.

In this environment, I think you'd like to own the stocks of companies that own things -- gold and iron mines, for example -- or that make things sold overseas.

And you'd like to make sure that you put a piece of the developing world's stock markets in your portfolio. I know, I know. The press is full of stories about a potential bubble in developing countries' stock markets. And I do think that's a real danger.

But the trend blowing in favor of these markets is so strong, and likely to last for so long, that I think it's worth investing a bit of time on these markets to figure out how to put some money into them without taking on more risk than you'd like.

After all, as I lay out in this column, I think that's exactly what the world's central banks are doing.

Why it will be gradual

In this column, I'm going to lay out the logic for a gradual dollar decline -- no reason to panic -- and for investing more in developing economies. In my next column, I'll look at the arguments for a dangerous bubble in these markets and name some stocks that will give you the exposure you want without taking on a ton and a half of risk.

Here's why the dollar is likely to keep dropping for a while:

• The U.S. runs a huge, though falling, trade deficit with the rest of the world, about $700 billion annually at current monthly rates. That leaves our trading partners holding an ever-expanding number of dollars.

• In recent years, only relatively higher U.S. interest rates -- and some premium from the economic stability that comes with being the world's biggest economy -- have kept demand for dollars roughly in step.

• As the economies of Europe and, for much of the year, Japan have grown faster than the United States in 2007, central banks in those countries have raised interest rates, cutting into the premium investors could earn by holding dollars.

• As interest-rate differentials have narrowed, as the U.S. economy has slowed and as a weaker dollar has cut the returns to overseas investors, demand for the dollar has weakened. And so has the price of the dollar.

That decline would have been much more precipitous if some of our trading partners hadn't actively propped up the value of the U.S. dollar. No altruism there, just straightforward self-interest. The Chinese government, for example, has continued to buy dollars (see my Oct. 5 column, "Our biggest export: Inflation") in order to keep the value of its own currency from rising.

Continued: They'll stick with dollars for now

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