2013 will be a good year for the US dollar

As Western governments seek to devalue their currencies, the US dollar looks likely to buck the trend. Matthew Partridge explains why, and picks the best way to play a strengthening greenback.

America has a problem.

Governments across the world are locked in a battle to weaken their currencies. A weaker currency tends to boost exports, and drive inflation higher. It's seen as an easy way out of the debts they've all built up.

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In the Budget, George Osborne all but begged the Bank of England to keep the printing pressing turned on; in Japan, the new central bank governor is expected to keep undermining the yen, in order to spark inflation; and in Europe, the Cyprus debacle has battered confidence in the euro once again.

In the US, Federal Reserve chief Ben Bernanke gamely keeps printing dollars. But try as he might, the currency wars' look like one battle that the US is set to lose.

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In fact, his biggest problem might be making sure that the dollar doesn't get too strong too quickly.

Here's why and what it means for your money.

The US deficit is set to shrink

If you're a regular reader, you'll know that we think the use of fracking' to access shale oil and gas is a big deal. According to Citigroup, America's vast shale reserves mean it could end up being a net exporter of energy by 2030.

Now, this might be overly optimistic 2030 is a long way off, and anything can happen. But what's undeniable is that the availability of cheap energy in the US has given the country a significant cost advantage in various industries. And firms are bringing production back from overseas as a result.

This reshoring' phenomenon means that more goods will be made in the US. In turn, this will result in a lower trade deficit (the gap between the amount the US imports and exports). In fact, the country may even turn its first surplus since 1975.

This will have a knock-on effect on the financial system. Instead of a constant stream of US dollars being injected into the global economy, as happens when the nation runs a deficit, the number of greenbacks available outside the US will start to shrink. Given the dollar's importance in global commerce, this will only drive the currency higher as supply fails to keep up with demand.

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Demand for dollars looks set to increase

Meanwhile, if history is any judge, there's a lot of room for demand for dollars to increase.

CrossBorder Capital focuses on liquidity and the way that money flows around the globe; the company has looked at the end of month of balance sheet holdings of all US dollar financial assets.

CrossBorder found that investor exposure to US dollar assets, as a proportion of worldwide financial wealth, is currently well below the average level since the series began in the 1980s.

What's more, CrossBorder reckons that holdings of US dollar assets tend to be "mean reverting". In other words, when US dollar holdings are unusually low, as they are now, they're likely to rise in the longer run.

This makes sense. As with any other market, investors constantly swing between optimism and pessimism on the dollar. In the early 1990s, everyone thought that the US was finished. At one point, investors had only around a third of their assets in the US.

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However, as the recovery took place, and it became clear that Japan, for example, wasn't going to take over the world, money started to flow back into the US. Eventually, global investors were holding about two thirds of their wealth in US assets. Similarly, in 2005-6, money flooded in to the States, only to reverse when the crisis hit.

So at the moment, it seems there is plenty of scope for more money to flow into the US. Rising demand and falling supply is usually a recipe for higher prices.

How to play the recovering US dollar

But how long will this take? According to CrossBorder, a useful leading indicator is the difference between the private sector savings rate, and the amount of liquidity provided by the Fed.

In the first few years after the US crisis, this was sharply negative, due to the amount of money the Fed was pumping into the economy. But in the past year, it has been positive, as firms have been saving lots of cash.

Over the last three decades, says CrossBorder, this indicator has been very good at predicting the performance of the dollar over the coming six months to a year. In short, it's now suggesting that the dollar will strengthen.

We've looked at various ways to get exposure to the dollar in the past. One way to make a direct bet on a stronger dollar is to buy the ETFS Short GBP Long USD (LSE: USD2). This tracks the exchange rate of the dollar against the pound.

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Of course, you can still lose money if the exchange rate goes against you, which could happen if the Fed decides to increase its money printing. Also, as with any currency bet, this isn't a buy and hold' investment. While it's lower risk than spread betting, you should monitor the trade's performance closely.

An alternative, longer-term bet would be to buy into the Mexican stock market. A stronger dollar will help firms in Mexico to sell more goods north of the border'. At the same time, rising wages in China mean that moving production to Mexico is an increasingly attractive alternative. The London-listed exchange-traded fund iShares MSCI Mexico IMI Capped (LSE: SMEX) gives you easy access to the Mexican market.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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