A very important factor is the positive balance of payments because it means that this country’s economy will not be dragged down by deficit spending. The strong leadership also includes evaluation of the ability of the central bank to provide price stability and to fight inflation. The yield is also important, although it is not a main reason for buying a currency. After all, it is the currency movement against the dollar that determines the return, not the yield. But the interest helps to offset downward movements of the currency, so it is also an important part of the decision.

In addition to those top three factors, we also look at the composition of the country’s GDP, whether the country produces something or whether the GDP is mostly made up of government spending. For example, in the current bull market for commodities, the strong producers of commodities like Australia, New Zealand, Canada, Brazil, South Africa, and Norway, have been the best performing countries. A great part of that demand comes from China and China has not slowed down despite the forecasts, so the demand for commodities remains strong.

Q: Historically, the U.S. represents the only economy that has managed to sustain both leadership and a trade deficit for more than five decades. What usually happens to the nations who live beyond their means?

A: The issue is debatable and economic historians point out that never a country run a deficit that large. In the last five years that deficit has multiplied to a huge amount without a currency crisis, or devaluation. But we have never seen any country devalue its way to prosperity. Forward-looking, if we can’t work ourselves out of this situation, we’ll probably see a currency crisis.

I think that the only country that can get away with mounting deficit is the U.S. because of its power and the strength of its economy. However, there is a point when the deficit just becomes too big, even for the U.S. At some point, the central bank of China, Japan, or another Asian country will say, “No more,” and will stop buying the U.S. debt. When that happens, we will see the interest rates rising or the dollar weakening. No one really knows when this can happen. It may never happen if we work ourselves out of that situation but, in the meantime, investors should diversify and protect themselves against a possible currency crisis.

Q: Could you illustrate how currencies provide the benefit of diversification to a portfolio?

A: During the first weak dollar trend, which lasted from 1971 through 1978, the Swiss Franc gained 186% against the dollar. The combination of Deutsche Mark, Japanese Yen, and Swiss Francs returned 131%. The next trend was a strong dollar trend from 1978 to 1985 and during that time the Swiss Franc lost only 47% against the dollar, so it preserved its relative strength.

In the next weak dollar trend, brought about by the Plaza Accord in 1985 and lasting until 1995, the Swiss Franc was up another 138% against the Dollar and the simple combination of Deutsche Mark, Japanese Yen, and Swiss Francs had a return or 171%. The next strong dollar trend lasted for 7 years, when in office was Robert Rubin, who believed that the strong dollar was in the best interest of the U.S. During that time, despite the boom of technology stocks, the dollar only gained back 30%. So, there is an actual trend of a downward slope for the dollar.

In the period 2002 to present, the Swiss Franc has lost its luster as a hard currency because it is no longer backed 100% with gold. Nevertheless, it gained almost 40% against the dollar and our simple combination of euros, yen, and CHF is up about 50%. I believe that those currency moves very well illustrate how diversification is an important part of an investment portfolio.

Q: Globally, there seem to be two distinct blocks, the dollar and the euro economies, and many Asian and South American economies are pegged to one of those currencies. Do you think that China may become another anchor, if it revalues its currency?

A: Yes, absolutely. China has slowly loosened the rein on the currency over the last couple of years. Now it allows a wider trading band on a daily basis and the currency has gained 10% in the last year. The IMF believes that China’s currency is probably 25% to 40% undervalued and, given a free reign, we may see the yuan becoming a strong currency that a lot of people would invest in.

We have also seen Kuwait, a relatively small economy, drop its currency peg to the dollar and that move has been beneficial to them. Saudi Arabia is also on the verge of doing so and it is a much larger country to test those waters. In general, I expect these countries either to allow their currencies to float or to attach them to a different currency, right now probably the euro.

Q: The hard currency is a luxury that most nations cannot afford. Germany went through a very difficult time to sustain its currency after it united with East Germany at a very expensive one-to-one ratio. What is your view on event of merging the old Deutsche Mark and the Eastern German Mark?

A: Yes, it was an important development. Many of the EU problems with the euro in 1999 were a direct result of all the debt that had been built in taking Eastern Germany back on. To meet all of the requirements of the Maastricht Treaty, they sold gold. It was the only was that they could lower the deficit and made the euro a viable currency. But they had lot of gold that they could sell, while we don’t have that luxury in the US.

The safety net of Germany, their wonderful reserve, is just not available to us. We depend only on the faith of the government that foreign countries would support the dollar. I hate to bring war and politics in a discussion of the economy. It is an expensive war, there are monetary problems, and it is hard to get full accounting of the war expenses.

Q: The currency markets tend to be more volatile than the equity markets. What signs should investors watch for?

A: There are two different types of currency investors. There are currency day traders, or people who worry about the day-to-day data, central bank talk and monthly economic data. The investors, who buy currency for long-term diversification, are looking for signs that show if the trend is still in place or if it is over. Obviously, trends don’t end or begin on a particular day, and there’s always plenty of indication that a currency is through its trend.

In the past, we would look for any type of central bank intervention, which is an indicator that a currency may be at the end of its run. The central bank usually has very deep pockets, and if it is selling the currency, then it seriously affects the market. Other factors include changes in the interest rate and falling GDP. These factors eventually weigh on a currency, even if it is not immediately. After three or four reports of declining GDP, you will most probably see lower interest rates and a weaker currency.