The U.S. dollar has enjoyed a rally since the middle of last year, partly as a result of the debt crisis erupting in Europe, taking the problems of the dollar out of the headlines. However, there are good reasons to believe that this rally is soon coming to an end as the dollar is back under attack again. First, Iran and India announced that they will start trading crude oil using gold instead of dollars. Then shortly after the Fed announced that it is going to keep interest rates low until 2014.
The announcement of the Iranian and Indian oil for gold exchange was a direct response to the sanctions put on by the United States and the European Union. The official line has been that Tehran must be punished for its ambitions to develop a nuclear weapon. This punishment has been in the form of sanctions against Iran's oil exports, and now further sanctions against its central bank.
These sanctions are nothing short of financial warfare. This latest sanction against Iran's central bank caused an immediate shortage of dollars, and as a result, the Iranian rial plummet 40% overnight, causing hyperinflation. But, for every action, there is a reaction and Iran retaliated by announcing that it will use gold as an alternative payment system. India has a large amount of gold and it is willing to trade it in exchange for oil.
These actions taken by Iran and India are not enough to severely damage to the dollar. The damage would come if this development becomes a trend and other countries follow suit. It would substantially hurt the dollar if large economies like China and Russia abandon the U.S. dollar payment system and use alternative payment methods like gold or commodities; effectively bringing an end to the dollar as the world's reserve currency.
The Reserve Currency
The U.S. dollar has been the only currency used to buy and sell crude oil since the early 1970s, and from that monopoly, the U.S. dollar slowly became the reserve currency for global trades of most commodities and other goods. The result was a massive demand for U.S. dollars, pushing up its value. This gave the U.S. government a vast pool of credit as all foreign countries stored their excess reserves in U.S. Treasuries.
This privilege gives the United States the ability to print large amounts of currency to finance domestic programs at home and military spending overseas. The inflation from this sort of money printing is absorbed by the vast amounts of dollars circulating around the world, so that much of the inflation is not felt back here at home.
Nevertheless, this constant money printing has slowly eroded the value of the dollar, causing other countries to be more reluctant to store their foreign reserves in U.S. dollars, and also to consider alterative payment methods for settling international trades. The latest action by the Fed to keep interest rates between 0 and ¼ percent through late 2014 is just one more action taken to undermine the U.S. dollar.
Similarities Between the U.S. Dollar and the British Pound
The amount of dollars held by central banks around the world has already been declining for the past decade and the latest developments are only perpetuating this trend. The chart shows the official foreign exchange reserves held by central banks.
The amount of U.S. dollars used for trade and held by central banks affects its value. Before the dollar was used to settle international trade the British pound was the reserve currency of the world. But that privilege was taken away from the British as fewer and fewer goods were traded in that currency. The result was a continuous drop in its value. The British pound lost 80% of its value against the dollar over a 50-year time period. The chart below shows the USD/GBP exchange rate since 1935. With a trend in motion away from the U.S. dollar as a reserve currency for settling trade, perhaps this is what's in store for the dollar.
With the U.S. dollar (UUP) under attack by the Fed domestically and by foreign nations overseas the dollar will continue to decline in value. I suggest investors seek safety in tangible goods such as physical gold and silver, and to some lesser extent financial instruments such as SPDR Gold Trust ETF (GLD), iShares Silver Trust ETF (SLV), and senior gold mining stocks like Barrick Gold Corporation (ABX), Goldcorp (GG), Newmont Mining (NEM), New Gold Inc, (NGD) and Yamana Gold (AUY).