Published: October 14, 2009

The dollar is out as the world’s predominant reserve currency.

Central banks around the world increased their foreign currency holdings by $413 billion in the second quarter, the most since at least 2003, according to data compiled by Bloomberg News. But 63% of that new cash was put into currencies other than the dollar. That’s a record-high percentage for any quarter with more than an $80 billion increase in holdings.

The dollar’s 37% share of new reserves is down from about a 63% average a decade ago.

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays PLC, told Bloomberg. “It looks like they are really backing away from the dollar.”

Englander predicts the U.S. dollar will drop another -3.3% over the next three months.

Developing countries have sold about $30 billion for euros, yen and other currencies each month since March, according to strategists at Bank of America-Merrill Lynch.

Not surprisingly, China -- the United States’ largest creditor -- has been the greenback’s most vocal critic. China doesn’t report its foreign currency holdings, but is thought to hold about $800 billion in U.S. debt.

Zhou Xiaochuan, Governor of the People’s Bank of China (PBC), in March released an essay entitled “Reform of the International Monetary System” on the PBC Web site.

Without explicitly mentioning the U.S. dollar, Zhou asked what kind of international reserve currency the world needs to secure global financial stability and facilitate economic growth.

Zhou called for the “re-establishment of a new and widely accepted reserve currency with a stable valuation” to replace the U.S. dollar -- a credit-based national currency. The central bank governor noted that the International Monetary Fund’s (IMF) Special Drawing Right should be given special consideration.

And it was reported just last week that China and the world’s top oil producers are secretly planning to stop using the U.S. dollar for oil trade.

The new plan allegedly being hatched would end the dollar’s role in oil trade and replace it with a basket of currencies that includes the Japanese yen, Chinese yuan, the euro, gold, and a new unified currency that would be shared by nations in the Gulf Cooperation Council. The GCC includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. Together, these Gulf nations hold more than $2 trillion in U.S. dollar reserves.

“These plans will change the face of international financial transactions,” one Chinese banker told the British paper. “America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate.”

Some analysts have warned that the dollar suffered a similar setback in 1995, only to regain its bearings and rally some +26% against the yen and +25% against the deutsche mark in the following two years. But in this case the United States is struggling to bounce back from the worst economic downturn since the Great Depression and U.S. monetary policy will be accommodative until a recovery is thoroughly underway.

Federal Reserve Bank of St. Louis President James Bullard said Monday that a falling unemployment rate is a precondition for an increase in the benchmark interest rate from near zero.

“You want some jobs growth and unemployment coming down,” Bullard said in an interview with Bloomberg Radio. “That is a prerequisite” for an increase in interest rates.

However, there’s so far been no sign that the job losses are abetting. The unemployment rate hit 9.8% last month and some analysts expect it to peak at 10.5% next summer.

So with more dark days lying ahead for the dollar, where can U.S. investors seek shelter from the storm?

The first, and perhaps the most obvious, answer to that question is commodities.

Cashing In On Commodities
Gold prices Tuesday surged to another record high of $1,069.70.

“We’ve had a weakening dollar today which has definitely been supportive of gold prices,” Carlos Sanchez, a precious metals analyst at New York-based CPM Group, told CNNMoney. Inflation is “a long-term concern” for many investors, he added.

Gold’s record-breaking rise coincided with a drop in the value of the dollar, which hit a fresh 14-month low.

Gold prices are up about +20% this year, and other precious metals have outperformed as well. Silver prices rose as much as +1.4% yesterday to $18.075 an ounce, their highest level since July 2008. Silver is up almost +60% year-to-date, but unlike gold, is still off 70% from its all-time high.

Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks says he sees the silver-gold ratio correcting to the more typical 55 to 1 after it skyrocketed to 70 earlier this year. But silver’s relative price ratio corrections tend to overshoot, he says.

“I see it going to 50 at least,” Krauth said last month when silver was trading at about $16 an ounce. “With gold at $1,000, that means silver could trade to $20 or even higher.”

That would be an +11% increase from silver’s current level.

Krauth pointed out that the iShares Silver Trust (NYSE: SLV) exchange-traded fund is one of the easiest ways to gain exposure to silver. Similarly, the SPDR Gold Trust ETF (NYSE: GLD) is a convenient way for investors to add gold to their portfolio without purchasing bullion.

Of course, there are other ways to profit from commodities without buying them directly. Investors could also up their exposure to commodity-rich nations, such as Brazil and Chile. Brazil’s Bovespa index has jumped +71% this year while Chile’s Ipsa rallied +46%.

Investors unable to trade on foreign exchanges might look to large resource companies that have listed American Depository Receipts (ADRs) on the U.S. exchanges -- Brazil’s Petroleo Brasileiro SA (NYSE ADR: PBR), or Petrobras, for instance.

Domestic Dealings
Foreign companies aren’t the only businesses profiting from the dollar’s demise. In fact, some analysts have attributed the large run-up in U.S. stocks directly to the dollar’s slide.

“The dollar’s weakness is attracting increased investment flow from foreign investors who on a dollar-adjusted basis are finding U.S. stocks cheap [compared] to their foreign peers on a relative valuation basis,” John Stoltzfus, analyst at Ticonderoga Securities, told the Financial Times. “We believe that as long as the dollar remains weak and does not plummet from current levels this trend is likely to continue to add support to U.S. stocks, particularly U.S. multinationals that have large exposure to foreign sales.”

Large U.S. multinationals that do much of their business abroad are doing exceptionally well right now, because a weak dollar makes their goods cheaper for foreign nations.

Yum Brands Inc. (NYSE: YUM), for example, beat third-quarter earnings estimates and raised its full year outlook because of strong sales abroad, particularly China.

The Louisville, Ky.-based Yum, whose stores include Pizza Hut and Taco Bell, earned $334 million, or 69 cents a share in its fiscal third quarter, compared to $282 million, or 58 cents a share, in the same period a year ago. The company said it now expects per-share, adjusted earnings of $2.14 in 2009, up from its previous forecast of $2.10.

“Our China business generated extraordinary operating profit growth of 32% in the third quarter,” said Chairman and Chief Executive David C. Novak.

Yum! added 328 new restaurants in the second quarter, including 118 in Mainland China. By 2013, China will account for 40% of the company’s operating profit -- up from 28% in 2008 -- while the United States and the rest of the world will each account for a 30% share, according to company projections.

Similarly, major U.S. exporters, such as Exxon Mobil Corp. (NYSE: XOM), are poised to gain. Exxon is a dual threat, because in addition to having a large international business, it also stands to profit from the higher oil prices that stem from dollar weakness.

Oil prices yesterday gained 88 cents, or +1.2% to settle $74.29 on the New York Mercantile Exchange (NYMEX). At one point, prices reached $74.47, just short of their yearly high of $75 reached on Aug. 25.

“Currency will be a big positive impact. The lower dollar has many concerns to it, but it has a benefit to multinationals, and I think that is a big expectation in terms of the quarter,” Chris Sheldon, director of investment strategy at BNY Mellon Wealth management, told CNBC.

Sheldon believes positive earnings surprises will be one factor that could keep the U.S. stock market moving higher in the short term.

“It appears the estimate for the third quarter earnings compared to second quarter are relatively on par,” he said. “Given there has been some improvement in the tone of the economy and you have this currency affect you have some upside.”

-- Jason Simpkins
Managing Editor
Money Morning