Currencies are not obedient. They too often go up when they should go down, and down when they should go up. This certainly could happen again this year, with the U.S. dollar beating the odds — as it did last year — and rising against key currencies.

When advisors are considering foreign investments for clients, they should determine if it is a global firm producing for global buyers, in which case currency moves should not have a big impact on returns, or a domestic business, in which case currencies could have a substantial impact, says Fred Sturm, chief investment officer at Toronto-based Mackenzie Financial Corp.

There is no argument that the greenback is overvalued in terms of economic fundamentals. One need look no further than the U.S.’s huge and rising trade deficit, now approaching US$800 billion (6% of GDP). A deficit of this magnitude can only occur if the currency is valued at levels that make homemade goods expensive both at home and abroad, thus encouraging imports and dampening export growth.

In other countries, a trade deficit of 5% of GDP would have sent their currencies plunging. The U.S. is the only country that can get away with a shortfall of 6% — or higher. That’s because the foreign appetite for U.S. investments generates sufficient demand for the US$ to moderate the impact of economic fundamentals and at times override them.

Nevertheless, many economists think the greenback will be forced down this year, probably in the spring once it is clear the U.S. Federal Reserve Board has stopped raising interest rates. Rising rates was an important factor in pushing the US$ up last year against the euro and the yen.

The most benign scenario would be a gradual decline in the US$, combined with an economic slowdown in the U.S. of sufficient magnitude to make a significant dent in imports and reverse the trade deficit. There is, however, a risk of a US$ crisis, with the currency going into free fall, in the next year or two.

But not everyone is pessimistic. Toronto economic and financial consultant Lloyd Atkinson sees no reason for the US$ to drop. Indeed, he thinks further strengthening is more likely. His reasoning is simple: the U.S. is the only economy that is growing strongly, increasing productivity and generating strong profits. In his view, it is the only game in town in terms of equity investing. At the same time, he believes the central banks in Europe and Asia will continue to support the greenback with large purchases of U.S. treasuries. A drop in the greenback relative to their currencies would hurt those economies by dampening exports to the U.S.

Conventional wisdom says the reason for the huge U.S. trade deficit is that Americans are consuming too much; witness the very high consumer debt loads — more than 100% of annual personal disposable income. Yet Atkinson disagrees. He says the problem is that the rest of the world isn’t consuming enough. This is not an issue as long as strong productivity growth keeps pushing up real wages in the U.S. Debt loads have been rising for a long time; in his view, they simply reflect the even faster rise in real assets. “Americans have never had as high net worth as they do today,” he says.

But most analysts think the U.S. trade deficit creates an unsustainable global imbalance. They believe the greenback has to drop as much as 20%-30% to dampen imports and increase exports sufficiently to lower the trade deficit. Some think this can be achieved gradually, but others think a severe recession will be caused by a collapse of the over-leveraged U.S. consumer, resulting in a sudden drop in the US$.

Analysts agree any decline in the US$ should be against Asian countries, particularly China. But that is not in the cards. China has started to move its currency upward, but very gradually. It rose 2.1% last July and 0.6% since. China can’t afford the drop in exports that would accompany a substantial drop in currency. It has to generate enough jobs for all the people moving to the cities from the rural areas or the country could face widespread social unrest.

That means there will probably be more appreciation in the euro and the yen, although not necessarily in the Canadian dollar. Canada is a major resources producer, so the C$ was an exception last year, ending the year 3% higher vis-à-vis the US$. Some think the loonie will fall a little this year, reflecting lower commodity prices; others think it will rise further.

@page_break@The higher C$ hasn’t yet hurt the Canadian economy because demand for our exports has remained strong in the U.S., the destination for 80% of our foreign sales. But lower export volumes and more exchange rate hikes could mean problems for Central Canada’s manufacturing.

European and Japanese firms have had some relief because their currencies dropped in 2005, ending the year 13% below starting levels. But if they rise again this year, there could be problems. The euro is now 35% above its low of March 2002; the yen is virtually unchanged.

John Arnold, portfolio manager at AGF International Investors Inc. in Dublin, says the euro could jump 15%-20% to US$1.35-US$1.40. That would put pressure back on and move more production to eastern Europe. IE