The Fed: Dump the Dollar, Save the Economy

By TOM LAURICELLA

The Federal Reserve is launching a renewed effort to shore up the U.S. economy, but in the process, the value of the dollar could be a casualty.

While most individual investors in the U.S. pay little attention to the ups and downs of the world's currencies, moves in this $4-trillion-per-day market both reflect and shape trends in stocks, bonds and commodities.

Ellen Weinstein

Should a weaker dollar be in the cards, that could help key U.S. stock-market sectors, such as technology, lift commodity prices such as gold and oil, and provide a profit tailwind for U.S. investors who put money overseas, especially in emerging markets. But a weaker dollar, taken in the context of the Fed's efforts to stimulate the economy, could ultimately push inflation higher -- a bad outcome for investors now flocking to bonds.

"There are massive ramifications everywhere you look," says James Swanson, chief investment strategist at MFS Investment Management.

Already the dollar has lost 13% against the Japanese yen this year. And even the euro, which was battered by the European debt crisis this spring, has gained 18% against the dollar since June. Weighed against a broader basket of currencies, the dollar is down 8% since late August when the latest move by the Fed began to take shape.

Last week, the Fed announced its plans to pump $600 billion into the financial markets by buying U.S. government bonds. The Fed is concerned that the struggling U.S. economy is vulnerable to deflation -- falling prices -- against the backdrop of high levels of unemployment and depressed home prices.

The Fed's goal is, in part, to prop up the financial markets long enough to allow the economy to heal. In addition, by keeping interest rates low, it hopes banks will increase lending rather than keep their money invested in bonds, which in turn will create more jobs.

To accomplish this, the Fed will embark on a second round of what is known on Wall Street by the cumbersome name of "quantitative easing."

The Fed, which controls the amount of money available in the country, essentially creates new dollars out of thin air and uses that money to buy existing U.S. Treasury bonds from investors. The move doesn't increase the government's debt.

By increasing the amount of dollars in the economy, the Fed effectively dilutes the value of existing dollars -- creating inflation to fight deflation.

Many investors believe that as long as the Fed is in easing mode, the dollar will be under pressure, especially against key emerging-markets countries such as South Korea and Brazil, where economic growth is much stronger and bond yields are more appealing than in the U.S. The U.S. dollar has already fallen by 5% this year against the Korean won and 4% against the Brazilian real.

This may seem a world away from U.S. investors, but it quickly hits home in the form of making imported goods -- such as televisions and clothing -- more expensive. Another almost direct impact is most commodities are priced in dollars no matter where they are produced. So as the value of each dollar is devalued, the number of dollars it takes to buy a barrel of oil rises. That can inflate the cost of everything from a tank of gas to copper pipe for a new kitchen.

But it provides investment opportunities. Commodities, through a low-cost, broadly diversified exchange-traded fund, are one option.

Over the past two years, the stock market has shown a striking tendency to move in the opposite direction of the dollar. While historically that link didn't exist, U.S. companies tend to make more money from overseas than in the past, especially among the biggest stocks that comprise the Standard & Poor's 500-stock index.

A weaker dollar would have the most direct impact on companies that are big exporters. U.S. technology companies, for example, often do a meaningful percentage of their business overseas. MFS's Mr. Swanson points to manufacturers as beneficiaries. "Aircraft equipment, turbines, electronic machinery ... we export an awful lot of that."

Traditionally, smaller-company stocks, such as those that populate the Russell 2000 index, have been seen as having their fates more closely tied to the U.S. economy and not the dollar. But Russ Koesterich, chief investment strategist at iShares, the exchange-traded-fund unit of BlackRock, sees a positive for small stocks. "Small caps have actually done well with a declining dollar," he says. The reason is that the declining dollar is part and parcel of the Fed's moves to pump more money into the system. That is aimed at boosting risk, he says, and small-cap stocks tend to do better when investors are willing to take on more risk.

A more direct beneficiary of a weaker dollar are U.S. investors who invest in mutual funds buying foreign stocks and bonds. That's because profits earned in a foreign currency instantly are magnified when the dollar falls in value. A favored destination of many global bond funds these days are emerging-markets bonds priced in local currencies. The thesis is that the bonds will fare well because of the strong fiscal positions and growth prospects in many emerging-markets countries, gains which will be multiplied as those currencies rise in value against the dollar.

A weaker dollar "gives U.S. investors a good opportunity to have nondollar investments," says Eric Stein, a portfolio manager of the Eaton Vance Global Macro Absolute Return Fund. For emerging markets, he says, "it makes the story even more compelling."

One important caveat: While a slow decline in the dollar can provide these opportunities, it's a different story should the dollar go into a free-fall. That could destabilize global financial markets. Another possible negative outcome would be if the dollar's decline comes along with increased protectionism in the U.S. or abroad that cripples the free flow of trade and potentially tips the economy back into recession.

Write to Tom Lauricella at tom.lauricella@wsj.com

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Gold, anyone?