The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

—Ernest Hemingway, Esquire, September 1935

Is there a bigger dog in global currency markets than the US dollar? A strong consensus is screaming sell. They have good reason—the United States has entered a veritable monetary and fiscal wasteland. With the national debt approaching USD 12 trillion, a projected budget deficit of 13.6 percent of GDP in 2009 (unmatched since World War II) and Bernanke tossing out greenbacks like confetti, the US dollar is about as popular as a mink coat at an anti-fur protest.

In the ETF space, investors are diversifying out of the US dollar in droves. More than USD 3.1 billion is currently invested in the 23 non-USD currency ETFs and ETNs, including nearly half a billion in the Canadian dollar CurrencyShares ETF (NYSE: FXC). State Street’s International Treasury Bond ETF (NYSE: BWX) alone has accumulated over USD 1.2 billion despite being a relatively new offering.

What’s our view on the US dollar and other foreign currency trends? Admittedly, currency forecasting can be a difficult undertaking … often humbling even the most astute investors. Opinions tend to vary widely. At any one time, there seems to be more views on the direction of foreign exchange rates than there are currencies. But, as always, reducing the noise, focusing on fundamentals and taking a longer-term view can produce more reliable results. Let’s first review some currency theory before presenting our outlooks.

Currency Theory 101

In simple terms, currencies can be looked at as the “stock” of a particular country. A firm currency should supposedly reflect a confident view in its quality … or at least, that used to be the case. In practice, currency forecasting methodologies and models vary widely. Some approaches simply focus on the concept of purchasing power parity (the level at which two countries are broadly competitive with each other given prevailing inflation rates). Others concentrate on measures of relative economic strength and resulting portfolio flows (i.e., a more attractive country growth profile will attract greater investment flows, creating demand for the currency and driving it upwards). Still others examine trade flows and attempt to determine the “equilibrium” exchange rate that brings a country’s current account into balance.

Our own methodology approaches currency forecasting from an “Austrian” theoretical perspective, incorporating some aspects from the above methods. Broadly speaking, however, we monitor no less than 5 different relative measures between currency pairs (monetary conditions, economic “dynamism,” inflation conditions, interest rates and external accounts). While these fundamental measures remain paramount, examining investor sentiment can also be very useful. In tradable financial markets, public opinion is usually unified and dead wrong at major inflection points, becoming too exuberant after prices have risen and too gloomy after they have fallen. Currency markets are no different, with extremes in opinion often registering shortly before major changes in trend.

The US Dollar and Other Ugly Ducks

With that currency theory primer in hand, let’s examine the current environment. Looking at the United States, and indeed much of the Western world, the conclusions are clear: policymakers are pursuing strategies that will lead to weaker currencies. Generally speaking, a debt problem has been met with more leverage … addressing the symptoms rather than the cause. Financial aid has been directed at mismanaged financial institutions and supporting the consumption bubble (e.g., “cash for clunkers”), instead of into capital spending and real economic production (policies that lead to high growth and stable currencies). And, in an apparent move of financial alchemy, an enormous amount of opaque mortgage debt has been shifted to government balance sheets … instantly converting commercial credits into sovereign debt.

What will be the ultimate result of these misguided policies? In the short term, a temporary pickup in economic growth can be expected. But risks remain high that this will be followed by a period of protracted stagnation as growth has effectively been borrowed from the future. Most importantly for our currency view, a rapid expansion in government liabilities can only lead to deteriorating sovereign credit quality and chronically weak currencies. But weaker currencies compared to what?

Attempting to answer that, a serious conundrum emerges. As Western governments similarly unleash an unprecedented wave of unproductive spending, many of these currency blocs face the same structural head winds. Suddenly, the game amounts to selecting exposure to the “least bad” currency. Consider the PowerShares DB G10 Currency Harvest ETF (NYSE: DBV). This ETF initiates a long position in the three G10 currencies associated with the highest interest rates and shorts the three currencies associated with the lowest interest rates (G10 countries are all advanced nations). The ETF works on a simple premise—portfolio capital will flow to the countries with the highest interest rates.

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