US Dollar’s Demise Greatly Exaggerated

Many investors are concerned about the future path of the dollar … and with good reason.

The Treasury is increasing the money supply in amounts never seen before or even imagined … all in an effort to avert a meltdown and stimulate a path to recovery. And as expected, there are no shortages of opinions about the trillions of dollars being created out of thin air …

To save the banks,

To extend life support to a failing auto industry,

To create jobs,

And to bridge the gap from soft consumption.

So when the government takes this desperate approach of printing money, the reasonable expectation is that your dollars will be worth less.

As a result, there’s a growing panic about the fears of hyper-inflation and the potential fall of the dollar as the world’s reserve currency.

But there is a powerful element to the fragile-dollar argument that is missing …

Currency Markets Do Not Operate in a Vacuum

Currency exchange rates do not have absolute value, only relative value. By that I mean currencies are valued based only on the relative strength or weakness of another currency.

The U.S. isn’t the only country that’s printing money like crazy.

And the United States is not the only country that has embarked down this path of printing money.

Major central banks around the world are pumping money into their respective economies AND pooling funds in coordination to help save less developed economies.

In this globally synchronized recession with like policy actions at the global leadership level, determining the impact on the dollar is not a simple cause and effect. Because in this environment, there is not a clear-cut, more appealing alternative to the dollar across economic competitors.

Other major developed market economies with dollar alternatives - like the UK, Japan and the Eurozone - are taking a very similar policy path and are falling harder than the U.S.

It’s not a good sign that the U.S. economy is shrinking by an annualized rate of 6.1 percent. However, this doesn’t look quite so bad when compared to the Japanese economy, which is contracting at a rate of 15 percent, and the Eurozone, which is falling off by 9.8 percent. And don’t forget that the political stability in Eurozone countries is far more fragile than here in the U.S.

Yet whenever the dollar is in a bout of weakness, speculation about its future always arises.

Still the World’s Reserve Currency

Anyone who shuns the U.S. dollar and dollar-denominated assets is taking a BIG risk.

From February 1994 to May 1995, the dollar lost about 20 percent against the yen and the deutsche mark. This fueled widespread belief that the dollar was in for a massive devaluation and would lose its throne as the world’s reserve currency.

Guess what happened? At the height of the frenzy, the dollar bottomed and then proceeded to climb 51 percent over the next six years!

Fast forward to today. The sentiment of a dollar rout is similarly building AND so is the questioning about its future position as the world’s reserve currency.

But what defines an international currency?

There are six overwhelming conditions:

1. History - a currency with a history of broad international acceptance tends to build deep roots,
2. Economic magnitude,
3. Well-developed financial markets,
4. Political leadership,
5. A strong military power,
6. And market confidence.

Sure, there are long-term inflationary challenges to be dealt with by the Fed down the road. But right now, confidence is the key factor. And with a global economy in unchartered waters, confidence becomes highly measured by the first five points above. These five conditions remain heavily in favor of the U.S. and the dollar as the international currency.

Also, when looking back at Japan’s experience, history suggests that quantitative easing is not necessarily a license to sell a currency. The Bank of Japan, the first central bank to engage in this unconventional monetary policy began a quantitative easing campaign in 2001, after a decade-long battle with deflation.

The campaign lasted more than five years, and during this period the yen strengthened by 25 percent versus the dollar.

The Dollar’s Cycles Argue For Long-Term Strength

The dollar has had five distinct trends since the fall of the Bretton Woods system. And those five trends have lasted, on average, roughly seven years. The most recently completed trend in the dollar ended in March of 2008.

That trend, which took the dollar to all-time lows, lasted 6 years and 8 months.

Now, based on this history, I believe that the dollar is in its next cycle of strength, which calls for a multi-year bull market.

First Deflation, Then Inflation

If the IMF is right and this global recession has the type of slow recovery associated with other globally synchronized recessions and financial crises, deflation could be the dominant concern for the next several years. That means the Fed has plenty of time before it has to turn its focus to inflation fighting.

But before inflation becomes the focus, the most important concern is stimulating the recovery. And right now, the outlook, both in the U.S. and globally, is uncertain at best.

The Fed warned in its recent FOMC minutes that the global financial system remains vulnerable to further shocks. In addition, the Fed predicts a weaker economy in 2009 and 2010 than their previous estimate and higher unemployment. These are all reasons to expect a global economic climate that has continued elevated risk.

And in an environment with elevated risk and elevated vulnerabilities to shocks, shunning the U.S. dollar and dollar-denominated assets is a BIG risk to take.

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.

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