January 5, 2010
The future of the dollar
While a gradually declining dollar probably has served to bolster U.S. economic growth, it is nevertheless prudent to remain cautious about the rate and duration of the decline. If the dollar were to suffer a cataclysmic fall, then the economy would likely contract. Large deficits and unprecedented injections of money into the economy are bearish for the dollar, and, accordingly, it is necessary to be watchful of how the dollar reacts to these conditions. Nevertheless, there are several factors that potentially are favorable for the dollar in the future.
First, currency values are determined based on the relative economic conditions of the issuing governments. While the U.S. economy may not currently be at its peak, it remains well ahead of most other developed economies. Therefore, the dollar is not likely to fall precipitously relative to foreign currencies. In fact, foreign central banks continue to purchase dollars, and no major country has any rational incentive to allow the dollar to collapse, as the negative implications would be global.
Second, the dollar may be oversold at its present levels. Despite the fact that the dollar is stronger than it was at the beginning of the subprime crisis, fewer investors are now bullish about the dollar. To the extent that history is any guide, when sentiment becomes so imbalanced, a period of value restabilization usually follows.
Third, monetary policy eventually will be tightened, interest rates will be raised, and the supply of money will be reduced. While the Federal Reserve has indicated in recent FOMC statements that it does not intend to raise interest rates until it believes that the economic recovery is self-sustaining, monetary tightening ultimately should support the dollar.
Fourth, some of the dollar’s decline can be attributed to investors “shorting” the dollar. By shorting the dollar, an investor effectively borrows the currency, sells it, and reinvests the proceeds in other assets, in what is often called a “carry trade.” Eventually, these short positions must be unwound by repurchasing dollars to pay back the lender. Consequently, when conditions change and investors seek to cover or close out their short positions, increased purchases of the dollar should support its value.
Finally, despite renewed calls for a multi-currency reserve system, the dollar is not in any immediate jeopardy of losing its status as the world’s reserve currency, if only because there currently are no legitimate substitutes. Moreover, even if such a shift occurred, it would likely occur over a period of many years, as was the case when the dollar replaced the British pound following World War II. Approximately two-thirds of the world’s official foreign exchange reserves are in dollar-denominated assets. Unwinding that level of concentration would take a great deal of time.
Conclusion
Given the unprecedented nature of the recent global financial crisis, investors should remain vigilant as they watch for any changes in global policies or circumstances that may adversely impact the financial markets. Yet, even in these times of uncertainty, the decline of the dollar to date does not necessarily amount to a “crisis.” A gradual and orderly decline actually could bolster the economic recovery, reduce the trade deficit, and increase productivity.
Elisabeth Talbot is the Chief Market Strategist of The Colony Group, a Boston-based registered investment advisor.
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