US Dollar Now The Second Strongest Currency In The World

Luke Burgess
updated | Author's Website

It’s almost like something out of the Twilight Zone.

The American economy is breaking down. But the US dollar is one of the strongest currencies in the world right now.

U.S. investment vehicles are crashing. Retirement funds have lost trillions. America has significant unemployment and the Federal Reserve continues to inflate the US dollar. Yet the greenback has outperformed almost every major world currency since the middle of summer.

How can this be?

The reeling finance and banking sectors currently has investors running and screaming from the speculative equity markets.

Of the three major U.S. indices, the Dow Jones (^DJI) has performed the best, losing 21.8% since July 15th. The NASDAQ (^IXIC) and S&P 500 (^GSPC) are down 26.5% and 25.3% respectively over the same period of time.

With such significant risk in the American economy we should expect investors to be dumping their U.S. dollars.

But this just isn’t the case.

And believe it or not: People are actually running toward the U.S. dollar for safety.

These investors will eventually get burned and a U.S. dollar collapse is inevitable. But in the meantime…

The U.S. Dollar is Now the Second Strongest Currency in the World

Governments, institutions, and private investors around the world have been selling their currencies for the U.S. dollar, pushing the value of the American money much higher over the past several weeks.

Except for the Japanese yen, which has just turned slightly higher against the greenback, every major world currency has lost significant value against the US dollar since mid-summer. Among the biggest losers have been the Australian dollar and Brazilian real, which have dropped 26.9% and 24.4% respectively against the U.S. dollar since July 15th.

Change in Value Against the US Dollar Since July 15, 2008
Australian dollar-26.9%
Brazilian real-24.4%
British pound-12.4%
Canadian dollar-13.6%
Euro-13.6%
Japanese yen+2.2%
Mexican peso-15.9%
New Zealand dollar-18.8%
South African rand-17.6%
Swiss franc-11.1%

It seems a bit strange that investors would be buying the US dollar right now, considering the myriad of problems currently facing the American economy. But the fact is the United States isn’t the only country with financial problems.

Every country in the world is facing its own economic challenges right now. As a result, foreign speculators have been rapidly selling their own domestic currencies and buying the U.S. dollar.

This influx of buying has effectively increased value of the U.S. dollar. I believe that this increase, however, will only be temporary and followed by a steep and abrupt drop leading to an official recession in the United States and the resumption of gold bull market. I’ll talk about all that in just a minute. First we need to answer…

Why Are Foreign Investors Buying the U.S. Dollar as a Hedge?

Despite a legion of fundamental problems, the U.S. dollar remains the most important reserve currency in the world today.

Throughout the last decade, an average of almost two thirds of the total allocated foreign exchange reserves of countries have been in U.S. dollars.

Currency Composition of Offical Foreign Exchange Reserves
’99’00’01’02
’03
’04
’05
’06
’07
US dollar
70.9%70.5%70.7%66.5%65.8%65.9%66.4%65.7%63.9%
Euro
17.9%18.8%19.8%24.2%25.3%24.9%24.3%25.2%26.5%
British pound2.9%2.8%2.7%2.9%2.6%3.3%3.6%4.2%4.7%
Japanese yen
6.4%6.3%5.2%4.5%4.1%3.9%3.7%3.2%2.9%
Swiss franc
0.2%0.3%0.3%0.4%0.2%0.2%0.1%0.2%0.2%
Other1.6%1.4%1.2%1.4%1.9%1.8%1.9%1.5%1.8%

This massive US dollar-denominated forex reserve base makes the greenback appealing to foreign investors who are looking to diversify out of their own currency in times of domestic difficulties.

The U.S. dollar’s reserve currency status does many positive things for America. It allows the country to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. It also permits the government to borrow money at a better rate, as there will always be a larger market for that currency than others.

But there’s a catch.

In the event that foreign holders suddenly decided to shift U.S. dollar-based holdings to assets denominated in other currencies, there would be horrific consequences for the U.S. dollar and economy. Fortunately changes of this kind are rare, and typically change takes place gradually over time. However, significant drops in foreign exchange reserves of the U.S. dollar do occur from time to time.

Between 2001 and 2002, foreign exchange reserves denominated in U.S. dollars dropped almost 6%. As world governments and large institutions flooded the market with U.S. dollars, the value of the greenback collapsed leading America into the 2002-2003 recession.

I expect a similar chain of events to occur in the next several months.

The Next Big Leg Down for the U.S. Dollar

I believe that the current accumulation of U.S. dollars will soon reverse. Investors will begin to buy back their foreign currencies pushing the value of the U.S. dollar lower than ever.

The U.S. Dollar Index, a measure of the value of the greenback against of six major world currencies, has increased 13.4% since mid-July on the back of this buying pressure. But the long-term trend is down.

Take a quick look at the 25-year chart of the U.S. Dollar Index below. You’ll see the that the index was on  a general trend down until it was turned around in the mid-1990s, a period characterized by significant growth in the United States. But after only a few years, the U.S. dollar was back on it’s downward track.

20081016_us_dollar_index.png

In the short-term foreign investors may continue to buy the U.S. dollar, pushing the value of the greenback ever higher. But there’s no doubt in my mind that the long-term downward trend in the U.S. dollar will continue.

Once the governments, institutions, and private investor who are buying the greenback right now begin to convert back to other currencies, I believe that the market will once again be flooded with U.S. dollars. This will lead to a collapse in value for the U.S. dollar and most likely another official recession.

When this all takes place, gold will inevitably resume its march higher.

I would not be surprised to see the U.S. Dollar Index below 70 as early as the first quarter of 2009. I believe that there is still a bit of short-term downside to gold as the value of the U.S. dollar continues to grow. However, I completely expect gold prices to break back above $1,000 in 2009. Get ready now.

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