Nearly everyone agrees that the dollar’s recent drop was due to an increase in investor risk-taking, a trend that began once the Armageddon scenario for financial markets was off the table.
Yet, many investors remain spooked by the possibility of a collapse in the U.S. dollar. These fears culminate from expectations for an increasing disparity between U.S. and foreign interest rates, as well as concerns about U.S. deficits and inflation. Also hurting is uncertainty regarding the role of the dollar in the world reserve system (I will touch on this more below).
Thankfully we haven’t seen signs of a disorderly decline, such as a significant sell-off in long-term Treasuries or a run-up in inflation expectations. Instead, the dollar’s decline has been gradual and marked by lower volatility in key bilateral currency markets. In addition, risk premiums on a wide range of dollar assets have fallen and there is no evidence of a rise in the cost of borrowing from the U.S. government.
The U.S. government appears to be operating under the theory that dollar weakness will benefit the U.S. by inflating our way out of debt and causing more exports. However, this thinking is flawed in that it assumes that capital stays put while the dollar devalues.
There is no shortage of unhappy campers. The Chinese are upset because their significant holding of U.S. debt will be paid back in devalued currency. The Europeans are worried since a stronger euro threatens to squash the export growth they are depending on to fuel their own economic recovery. Thus, weak dollar policies risk driving away America’s largest creditors just as the Treasury relies more than ever on foreign investors to fund enormous spending programs.
But as much as some foreign leaders want to replace the dollar as the world’s reserve currency, there is no suitable substitute. The euro is widely respected, but lacks backing from a single sovereign debt market. China’s renminbi is out of the question since it is pegged to the dollar and not fully convertible. The Russian ruble isn’t a candidate because there is not enough of the currency to handle the volume of world trade and it can’t be relied upon to holds its value, especially if oil prices collapse. Other minor currencies couldn’t handle large inflows without becoming quickly overvalued.
The fact of the matter is that the Treasury market remained highly liquid throughout the financial crisis despite shattered confidence in other U.S. credit markets. Thus the dollar functioned as advertised, as a global haven, proving that U.S. government bills are still the best assets to have in a crisis.
I’m sure everyone would breathe a little easier if the Fed raised interest rates or Congress addressed its spending addiction. Regardless, it’s hard to imagine the dollar’s role in the world’s currency system changing anytime soon. If there ever is to be a change to the world’s reserve currency, it is perhaps more reasonable to expect a gradual shift to a basket approach in which the euro and renminbi play a more substantial role supplementing the dollar.
Peter J. Lazaroff, Investment Analyst
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