In the post-World War II era, the US dollar has been the world’s currency franca. It comprises 62 percent of foreign exchange reserves while the next largest, the euro, accounts for just 24 percent.

The dollar has managed to retain its reserve currency status for more than six decades for several reasons. The US boasts the single largest economy in the world, a distinction that is likely to last for many years to come.

The US also has one of the deepest and most liquid financial markets in the world, making it easy to buy and sell US Treasury bonds in huge volumes without significantly moving the market, especially in times of crisis.

Given these factors, changing the world’s reserve currency isn’t quite as easy as just saying that, from now on, the euro or the yen will be it.

But eventually that inertia will be broken. Below, we look at specific ways for investors to prepare their portfolios for the dollar’s day of reckoning.

As you can see from “Waning Confidence” below, for much of the 2000s the US dollar was steadily losing value as compared to a basket of global currencies. Large structural deficits, mediocre if predictable growth and global military adventurism all played a role in declining confidence in the dollar.



The only reason that tide turned was the Great Financial Crisis of 2008-2009, which struck with a vengeance and has kept the value of the dollar in a tight range ever since. The dollar became the ideal safe haven again because of the aforementioned factors, particularly the depth and liquidity of US financial markets.

However, the world economy has steadily recovered over the past few years—in particular, the European debt crisis has stabilized. Consequently, the dollar is once again losing its luster. All of the same structural factors that had contributed to its decline over the last decade are still in place; we’ve also entered an era of political gridlock that is only further sapping the dollar’s credibility.

Major dollar holders such as China get nervous, when US policymakers play a game of political chicken with the economy. Some have even professed that a default on the country’s debt wouldn’t have a real impact on the global economy. Look at the scope of the global financial crisis that was precipitated by the collapse of Lehman Brothers, which had liabilities of $517 billion, and then consider that the US government is sitting on a debt of $12 trillion.

The next US economic crisis would most likely be one of confidence, which would be brutal on the value of the dollar. Of course, it would be tough to abandon the dollar, but it can be done. Just ask the British, whose pound sterling dominated global trade from the 1860s well in the 1930s, losing prominence only when the Bretton Woods system of international monetary management was put into place in 1944 and the dollar rose to dominance.

The key feature of Bretton Woods was a mandate for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the US dollar.

And when the dollar’s dominance slips into the history books, we can expect higher interest rates as borrowing costs for both the government and private businesses increase and for inflation to spike as the dollar’s purchasing power in the international markets plummets.

Outlook

While I am most definitely a dollar bear, I’m not looking for the dollar to simply nosedive. Rather, I believe we’ll return to the last decade’s trend of slow erosion. That has already begun with the Dollar Index returning only about 0.5 percent through the first half of the year while the euro has decisively outperformed, just as it did last year. In fact, the euro has been the best performing G10 currency this year.

When you consider that so far the euro zone recovery has been even more tepid than that of the US, with the only real point of differentiation being its small current account surplus, that outperformance boils down to confidence.

Notably, while the US has relied on stimulus to boost the economy out of recession, the Europeans initially relied on structural reforms and have only recently begun stimulating in any meaningful way.

The dollar’s crisis of confidence will likely be exacerbated when Congress and the Obama administration rejoin the debt ceiling battle in February. While most everyone was relieved when the government reopened on October 16 following its longest shutdown in history, the agreement reached by the administration and Congress only kicked the debt ceiling can down the road. When that battle resumes, the Europeans will appear to be the paradigm of level-headiness.

As a result, the euro will likely continue to outperform the dollar at least over the next year. I also look for Asian currencies to outperform over at least the next year as well.

While many emerging market currencies have taken hits over the past few months as the US Federal Reserve has talked of tapering, most Asian currencies have performed positively.

After taking their lumps during the Asian currency crisis of the 1990s, most Asian countries run current account surpluses and hold substantial reserves of foreign currencies. As a result, their currencies are more structurally attractive even as Asian central banks generally have the firepower to fight back any currency speculators.

How to Hedge

In light of these trends, it’s prudent for you to adjust your currency exposure. Below are the best ways.

The first is to buy stocks or other assets in local currencies, such as Mitsubishi Estate (Tokyo: 8802, OTC: MITEY). When you purchase shares of Mitsubishi on the Tokyo exchange, your dollars are being converted into yen and thereby provide currency diversification.

Another option is to purchase funds such as iShares MSCI Australia Index Fund (NYSE: EWA) which, while traded on a US exchange and traded in US dollars, holds stocks priced in Australian dollars and doesn’t hedge its currency exposure. About half of the fund’s 11.8 percent return since I added it to the portfolio back in August has been largely due to the weakening dollar.

Alternatively, investors can also take a more proactive approach without having to open a Forex account, thanks to a number of terrific funds that have become available in recent years.

Guggenheim CurrencyShares Euro Trust (NYSE: FXE) allows investors to make direct bullish bets on the euro by simply going long the fund. Bearish bets can be made by selling fund shares short.

JPMorgan Chase (NYSE: JPM), the depository for the trust, maintains a deposit account denominated in the euro equal to the fund’s assets, currently $273 million. As a result, it closely mirrors the performance of the euro relative to the US dollar, less its 0.40 percent expenses.

Following a brief selloff following the European Central Bank’s rate announcement, Guggenheim CurrencyShares Euro Trust rates a buy up to 150.

CurrencyShares maintains a wide array of funds that allow investors to make direct bets on nine international currencies. A listing of them can be found at www.currencyshares.com.

The best way to make a single bet on a basket of Asian currencies is Merk Asian Currency (MEAFX, 866-637-5386).

Portfolio manager Axel Merk uses fundamental analysis to identify those Asian currencies he expects to outperform, paying close attention to factors such as trade balances, gross domestic product growth and inflation. Those currencies he expects to outperform are overweighted in the portfolio.

Since the fund’s inception in 2009, it has consistently outperformed its peer group with the exception of last year when it lagged by -0.7 percent. It has also been consistently less volatile than most other currency funds, despite its general outperformance.

An open-ended mutual fund does have the disadvantage of requiring a $2,500 initial investment, but adding a position in the fund to your holdings makes terrific sense if you’re expecting a dollar decline.

Merk Asian Currency is a buy at current prices.