Q: What is the general philosophy behind currency investing? Why should investors consider currencies?

A: We view currencies as a different asset class, not as an alternative investment. Since currencies have low correlation with other investments and different pricing mechanisms, they provide adequate diversification. In essence, as a separate asset class, currencies provide diversification and a hedge to a portfolio, regardless whether we are in a period of a strong dollar or a weak dollar.

Currencies should also be considered for tactical reasons. When you understand well the economy of a particular country and the valuation of its currency, you can buy or sell that currency to take advantage of its moves. Nevertheless, we believe that people should not invest more than 10% to 15% of their portfolio in a currency. Only in periods when currency investing provides a great advantage, investors should go up to 20%, so we still treat currencies as an asset class.

Q: What are the major drivers behind the currency fluctuations?

A: We have been investing in currencies since 1985, so we have tracked and researched many of the currency trends. There have been only four completed currency trends since the collapse of the Bretton Woods system in 1971, when the U.S. suspended the convertibility of the dollars to gold. Since then we have seen alternating trends of strong dollar and week dollar, which last anywhere from 7 to 10 years and represent long sweeping moves.

There is always a fundamental reason for a trend to start or end. The dollar remains in that trend until the fundamental reason is corrected, or at least is down the road to correction. More importantly, a trend is not a one-way street. Of course, there is volatility within a trend, such as the signs of strength in the current weak dollar period, but as long as the dollars remains on the trend, it always comes back to the underlying fundamentals.

Q: What are the fundamentals that pushed us into this period of a weak dollar?

A: The weak trend, which began in 2002, is based on a couple of factors. First, the administration instituted tariffs on steel. Whenever a protectionist measure is introduced, the currency is harmed. Investors started to look at the fundamentals of the dollar and question whether they should continue to buy dollars.

At the same time, the U.S. current account deficit reached a level of 4.5% of the GDP. Historically, whenever that level had been reached in other countries, it has been an indicator of future currency problems. Although in the case of the U.S. those problems are less severe, the deficit harmed the dollar and pushed it into a weak trend.

Today the current account deficit has grown to about 6% of the GDP, so we haven’t seen any step towards correction. That means that the weak dollar trend will probably continue because it requires up to $3 billion a day in foreign investments to finance the deficit. In addition, when you lower the interest rates, like the Fed recently did, that lowers the yields on the investments that foreigners would buy. So, going forward, I see the major problem in the U.S.’s ability to attract $3 billion in foreign investment every day without a significant adjustment in dollar price in the international markets.

And when a country has a problem attracting enough foreign investment to cover its deficit, there are only two things that can happen to correct this trend. The first one is raising interest rates to attract foreign investments. But with the Fed cutting rates, I doubt that we will see a sudden turnaround. That seems to be out of the question because raising the rates would have brought the economy to its knees.

The second possible measure is allowing the currency to be debased, or allowing the currency to get weaker. In that way, when foreign entities buy assets in the U.S., they have to convert their currency to dollars. If they can buy them at a cheaper dollar price, that’s means that they are buying the asset at a discount. Comparing the two measures, the choice for currency debasement is pretty obvious. That is what we see happening right now and that’s going to continue until the deficit is corrected.

Q: As a larger economy, we have managed to sustain low interest rates for years without the inflation picking up. Nevertheless, do you think that a slowdown, combined with higher inflation and weaker currency, is possible?

A: Yes, in fact I believe that this is where we are heading. The economy has already been slowing down. The job growth is much slower, affected by the mortgage and the housing meltdown, whose effect goes far beyond the housing market.

However, as an ‘old school economy’ person, I believe that there’s nothing wrong with recessions. When we were in a short recession 4 or 5 years ago, the Fed brought us out of that very quickly by lowering interest rates down to the bone and enticing people to spend. But we never really got a chance to clean out the excess of the previous boom. The past recessions haven’t killed us; they have made us stronger for the next growth period. I believe that the longer you put off the inevitable, the worse it will be when it actually comes around.

So I believe that a recession is coming, that interest rates will be much lower, and that the dollar will be weaker. The Fed will cut interest rates at least once or twice this year and the dollar will ease further down, especially against the Asian currencies. Most individuals in the U.S. don’t notice the decline of the purchasing power of the dollar because many of the goods they buy are made in Asia and the dollar hasn’t lost ground against the Japanese yen and the Chinese yuan. Since 2002, the euro is up 64% against the dollar but the yen is up only 15% and the yuan is up only 10%.

But we will never get a correction in the deficit until those currencies do increase against the dollar. That’s why Henry Paulson, the U.S. Treasury Secretary, is always hitting on China to allow its currency to float. If that happens, our manufacturing will become more competitive. In other words, their goods will become more expensive and we could get some control over the spending and the current account deficit.

That means that the ‘strong dollar’ policy doesn’t really exist despite that fact that in the past six or seven years all the Treasury Secretaries talked about it. At the same time, they also talk about Japan and China floating their currencies, which would lead to a weaker dollar. So we started currency investments as diversification, but we moved into a tactical approach because we believe that, going forward, the dollar will continue to be weak.

Q: Starting with the premise of a weak dollar, how do you select the currencies to invest in?

A: I believe that when you select currencies, you should view the currency as the stock of a country and analyze it in the same way as stocks. You should look for countries with good balance sheets, strong leadership, and reasonable yield.