Euro, yen make dollar look good

By Jim Jubak

The U.S. dollar is rallying against both the Japanese yen and the euro -- up about 7% against the yen and 9% against the euro this year -- despite a steady drumbeat of bad news.

What seems puzzling at first is perfectly understandable if you remember that a currency doesn't have to be perfect or even particularly solid to gain value. All it has to do is be less bad than the alternatives. And right now the U.S. dollar is the least-bad currency in the world.

The comparative superiority of the dollar won't last forever, but I'd give it at least six more months to run -- and maybe more. That's long enough so that investors need to incorporate the outperformance of the dollar into their investment strategies:

• A stronger dollar will take a bite out of earnings at U.S.-based multinational corporations such as Deere (DE, news, msgs), PepsiCo (PEP, news, msgs), Coca-Cola (KO, news, msgs) and McDonald's (MCD, news, msgs) because these companies will see international revenue converted from weaker currencies into fewer strong dollars.

• A stronger dollar means oil producers get more purchasing power for a barrel of dollar-denominated oil even if the price doesn't increase.

• A stronger dollar will slow the rise of gold, because a strong dollar gives nervous investors an alternative to the shiny metal as a store of value.

• And over the long run, a strong dollar makes international investments in weaker currency countries cheaper, whether you're a company on the prowl for acquisitions or an investor looking for stock bargains.

Let me start by explaining why the dollar is the world's least-bad currency and then suggest some investment ideas built on a stronger dollar.

How the yen fell from grace

The yen had been the world's safe-haven currency for much of this bear market. No more, though. Most of the blame rests on the Japanese economy and Japanese politicians. In the fourth quarter of 2008, the Japanese economy contracted at an annual rate of 12.7%.

That's the worst performance since an annualized 13.1% decline during the 1973-74 oil shock.

And with Japan's economy based on exports, the numbers are likely to get worse before they get better. Japanese exports fell 46% in January 2009 from a year earlier. That's the biggest drop in 50 years. The collapse in Japanese exports is a direct result of the 23% appreciation of the yen against the dollar in 2008. That gain made Japanese goods more expensive for U.S. consumers. Eventually, a cheaper yen will help fuel a rebound in Japanese exports, but the process is likely to take one or two years, economists say.

All this wouldn't matter quite so much if Japan hadn't gone into this latest crisis with the largest debt relative to the size of its economy of any country in the industrialized world. Japan's debt at the end of 2008 stood at 170% of its gross domestic product. (Italy comes in second-worst at 117%. The United States, at the end of September, showed a debt-to-GDP ratio of about 40%. A lot has changed since then, and the Congressional Budget Office now estimates the U.S. debt to GDP ratio will climb to about 70% within three years.)

The euro's plight

In the world of least-bad currencies, however, the yen isn't in the worst short-term shape of the global Big Three. That distinction goes to the euro, because of the economic and financial meltdown in Eastern Europe, where governments and consumers borrowed hand over fist when credit was easy. The bubble now deflating was huge, even by recent U.S. standards. Imagine, if you can, the U.S. mortgage crisis on steroids.

East European banks took the U.S. no-income, no-assets, no-down-payment, no-income-verification mortgage a step further: They pitched mortgages denominated in strong currencies, such as the Swiss franc, that came with lower interest rates. However, now that East European currencies are sinking like stones, these mortgages are becoming more expensive. The Polish złoty, for example, tumbled 35% against the Swiss franc in the six months ending Feb. 26. In the same period, the Hungarian forint was down 28% against the franc. The złoty and the forint are down 25% and 15%, respectively, against the euro in the same period.

East European homebuyers and consumers weren't the only ones who loaded up on foreign loans. Governments and corporations in these countries took on debt to finance their growth. Many of those debts are now coming due. The government of Hungary has $15 billion in short-term debt due this year, and the government of Ukraine about $30 billion, for example.

Companies across the region need to refinance about $200 billion this year.

Continued: Running for the exits

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