The Dollar's Continued Decline: Unintended Consequences

Includes: UDN, UUP
by: Ray

Whether it is really an intended consequence or not is up for debate, however what is clear is the dollar's rapid rate of descent to the basement. The index has been lower in the past, but the economic crisis last year boosted the dollar’s strength against every major index until the early part of summer when the risk and inflation trade kicked into high gear.

The consequence of a weak dollar is of great concern to me as it has consequences that most Americans either do not know about or do not fully understand. A weak dollar is good for our exports, but it also has an inflation factor for us that can sneak up on people. Commodities are priced in dollars so when the currency declines everything we use on a day-to-day basis increases such as gas and food. While the government thinks that gas and food have no or limited inflationary effect on people, I have to disagree since most people like to eat everyday and occasionally fill up their gas tank.

There is no question between the correlation of a weak dollar and the upward momentum of the equity markets. There are various reasons why the market has gone up over the past few months, it was massively oversold, but clearly the weakness in the US Dollar was perhaps the largest contributor to equities gains. As you can see below (), the correlation is obvious between the dollar’s weakness and rising equity prices. Although there seems to be a decoupling between the two over the last few days, the longer term correlation is still very evident.

dxy spy

Every time the dollar declines 1% we see about a 1% increase in equities which means there is no real gain in stocks as Americans' buying power was simply reduced. The reason for the dollars descent, which has been years in the making I might add, is because of our loose monetary policy. That policy has become increasingly looser since the beginning of the financial crisis and the saving grace of the US dollar was its liquidity as investors bought up dollars at a record rate last fall.

There seems to be no sign from the Fed as to when interest rate tightening might happen although many think interest rate hikes are closer than we think. Tightening our interest rates is the best way to support the dollar along with fiscally responsible spending which would mean no more spending by our government at this point. However, personally, I do not think the Fed has the stomach to tighten rates anytime in the near future, perhaps in 2010, but the Fed has been influenced way too much by the markets. In my opinion the Fed has abandoned its original role.

On top of a poor monetary policy we also have massive amounts of debt being issued by the Treasury which is diluting our dollar even more. At this stage, we are heavily dependent on foreign governments to buy our debt. We saw what could happen if foreign governments slow or stop their purchases during last week’s 2 year auction where the bid-to-cover was 1.92 and rates shot up. If foreign governments stop buying our debt we are in huge trouble and will have to do more “quantitative easing” than we currently do now.

If the dollar index continues to slip then we could be facing huge problems such as losing our status as the world’s reserve currency. The only thing preventing that now is the fact that there is no other market that can handle being the reserve currency. The Euro and Yen are contenders, but those markets still are not as deep and liquid as the treasury market.

However, if we do lose our reserve currency status or the dollar index slips into the 60 area, it is possible that foreign banks will start dumping the dollar, which could start the beginning of a crisis in the US dollar. As of right now I see an orderly exit out of the dollar, but if the orderly exit turns into a run for the exit because someone smells a fire then that is when we will have a big problem. It could very easily turn into a dollar collapse and no one is really sure what would happen because it has been unfathomable at any other time in our history.

Not only have we never seen anything like that in our lifetime in America, but most people think it could never happen, presumably because we are America. Not only could it happen, but eventually it is more than likely a probability that it will happen. Clearly no one knows exactly when or how it will happen, if it happens at all, but one thing is for sure: it will be because of a lack of confidence in the US dollar.

I do not root for such a thing to happen and I hope it never does happen, but at the very least it looks as though the greenback will have some tough times ahead. This is one of the reasons why I am bullish on international investments, gold, silver and other hard assets as they are a hedge against a weak dollar. Buying commodities is one of the best ways to protect and preserve your buying power.

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