Overvalued Dollar, Undervalued Euro

04/28/2010 12:00 pm EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

Axel Merk, president of Merk Investments LLC, and portfolio manager Kieran Osborne, explain why the dollar may go down and the battered euro may rally.

We continue to see risks ahead for the US economy, and in particular, the US dollar.

Of grave concern is the unsustainable federal budget deficit, which may have morphed out of control, with no signs of government restraint over the near-term. The US current account deficit remains at a high level, and will likely weigh on the dollar for years to come.

Despite political rhetoric to the contrary, in our assessment, policies are clearly working against a strong US dollar. Moreover, we are yet to see evidence of a strong, sustainable economic turnaround in the US. Debt levels remain high, and what debt is not being driven by private sector demand is more than made up for through insatiable government debt growth. Until we see fiscal and monetary restraint in action rather than words, we consider the medium and long-term risks remain to the downside for the US dollar.

We consider there to be many attractive currency investment opportunities. Of particular interest is the Asian region and those countries well placed to benefit from ongoing Asian demand.

In our opinion, rapid Asian domestic economic growth will create increasing inflationary pressures. Indeed, China has recently clamped down on bank lending and India has raised interest rates in response to such pressures. We believe the Chinese approach to containing inflation is highly ineffective, and that currency appreciation may be a much better solution to tame domestic inflationary pressures.

An Asian currency we are not currently in favor of, however, is the Japanese yen. We harbor concerns over the long-term viability of the country’s ability to service its enormous levels of debt in light of unfavorable demographics—specifically, an aging, shrinking population. Moreover, recent initiatives have us concerned that the Bank of Japan may now reignite its quantitative easing policies, which had lain dormant throughout much of the credit crisis.

Lastly, there has been a lot of concern surrounding Greece’s woes and the spillover effects on the rest of Europe and the euro. Unlike many other market participants, we see considerable value in the euro on a long-term view.

We believe that Greece will ultimately be seen for what it is: a low single digit percentage of euro zone [gross domestic product]. In our eyes, the euro will not only survive, but may offer significant upside potential.

Given the spluttering economic recovery outlined above, we consider the Fed may expand its balance sheet once more in the next economic downturn, devaluing the US dollar, while the European Central Bank is likely to continue to follow much more prudent monetary policies.

Therefore, while the euro zone may experience weaker economic growth, it is likely to be on the backdrop of a stronger currency. Relative to the US dollar, the euro may retain significant value.

Read more commentary from Axel Merk at the Merk Mutual Funds Web site here…

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