By David Peartree
The Daily Record Newswire
What happens when a faith-based currency begins loosing the confidence of the faithful? With the U.S. dollar, we may find out over the next several years. The implications for investors could be significant.
The U.S. dollar is a faith-based currency. It is backed solely by the good faith and good credit of the U.S. government, and both are beginning to erode. There are several ways to measure the value of the dollar and they all suggest a dollar in decline.
Start by looking at the dollar in comparison to other currencies. The dollar has been weakening for the last 10 years, whether measured against the Euro or against a basket of the major currencies. There was a period of renewed dollar strength during the 2008 financial crisis as investors fled to the dollar for its relative safety and again in 2010 when the Euro struggled.
Even so, the long-term trend, which again became evident in 2011, has been a weakening dollar. Currency exchange rates offer the clearest indication of the dollar's trend but two other indicators are offering confirmation.
The level of foreign currency reserves held in U.S. dollars is another indication of the dollar's status. Strong export economies, China being a prime example, end up with excess or reserve funds which they choose to hold in other currencies such as the dollar. This is done both as an investment and as a way for the foreign country to protect its own currency's value.
A falling dollar decreases the value of foreign reserves held in dollars and creates an incentive to move foreign reserves elsewhere. According to the International Monetary Fund, the level of foreign government reserves held in U.S. dollars declined from the third quarter of 2008 through the first quarter of 2011.
China and a few other countries have suggested the need for an alternative to the U.S. dollar as a reserve currency. At the moment there is not a viable alternative to the massive U.S. dollar market and any significant shift away from the dollar would likely occur gradually. However, the open venting of frustration with our monetary policy and the devaluation of the dollar suggests that the dollar's preeminent status in the global markets is no longer a given.
Demand for U.S. Treasuries is a third indication of the value of the dollar. Even with the recent downgrade of U.S. debt, demand has held up because it remains, on a relative basis, the safest and largest port in a storm. Still, the downgrade by Standard & Poor's was a warning shot not to be ignored.
Bill Gross, one of the most prominent U.S. bond managers, estimates total U.S. debt at something in excess of $60 trillion if one includes the present value of the major entitlement programs -- Social Security, Medicare, Medicaid. That is a staggering number, several times the size of our current GDP.
He makes, in effect, a simple supply and demand argument: The massive amount of debt needed to be issued to service that burden can't but have the effect of pushing Treasury prices down, rates up, inducing inflation, and devaluing the dollar in the process.
A primary reason for the dollar's decline has been the Federal Reserve's easy money policy, first under Alan Greenspan and more recently under Ben Bernanke. The Fed has kept short-term interest rates near zero for a prolonged period hoping to support economic growth. Two rounds of quantitative easing and money printing have also contributed.
Both the Bush and Obama administrations have claimed to support a strong dollar, but their claims have not been credible. The U.S. is the world's largest debtor nation and the unofficial policy of our government appears to be to repay our massive debts using dollars that become worth less over time.
The dollar's trend has implications for U.S. investors. Dollar-based investments face headwinds from a falling dollar, but non-dollar based investments should benefit from tailwinds. If a foreign currency gains in value relative to the U.S. dollar, then foreign investment returns get a boost when calculated in dollars. There is no assurance, of course, that even with a weak dollar foreign stocks and bonds will outperform U.S. stocks and bonds.
For most individual investors, the most effective way to address the long-term trend of a weakening dollar is through an appropriate allocation to foreign investments. Most investors understand by now the importance of exposure to foreign stocks. Even so, some may find themselves under-allocated to foreign stocks and want to reconsider this in light of the dollar's trend as well as the better growth prospects in other parts of the world.
Exposure to foreign bonds is a newer concept for many investors. A weakening U.S. dollar is just one of the potential challenges facing U.S. bonds in coming years. Having some exposure to foreign bonds is a way to mitigate risk.
The trend of the U.S. dollar is one of the primary indicators the long-term investor can use to shape decisions about asset allocation and diversification.
David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. He can be reached at email@example.com.
Published: Tue, Aug 30, 2011