The Beginning of the End for the Mighty US Dollar

It looks the rest of the world is getting tired of using the once mighty Greenback as it’s reserve currency. Recent reports show that China and other emerging super powers have started seriously calling for the creation of a new global currency to eventually replace the US dollar. China, the largest foreign holder of US debt ($2 Trillion), is behind the current push for moving away from the global fiat currency because of frustration at their financial dependence on the U.S., with Premier Wen Jiabao this month publicly expressing “worries” over China’s significant holdings of U.S. government bonds. President Obama was forced to publicly assure the Chinese that all is well. Because other nations continued to park their money in U.S. dollars, the argument goes, the Federal Reserve was able to pursue an irresponsible policy in recent years, keeping interest rates too low for too long and thereby helping to inflate a bubble in the housing market.

It’s still early day’s and calls for moving to a non-US dollar world standard are not new. In fact, the EUS dollar reserve graphicuro was starting to do this, but the global recession has placed a lot of stress on Euro member countries which in turn raised fears about the Euro’s stability. Further more, the technical and political hurdles to implementing a new global currency are enormous, so even if backed by a coalition of nations, it is unlikely to change the dollar’s role in the short term. This is clearly demonstrated by the fact that central banks around the world hold more U.S. dollars and dollar securities than they do assets denominated in any other individual foreign currency combined. However, the longer term (5+ years) picture is not that great for the US dollar and eventually the current deficit spending will catch up.

The appreciation of the dollar over the last few months was primarily due to a perceived flight to safety in US treasuries, which foreign investors and governments bought as other asset classes became more risky. However with all the trillions in stimulus spending, bank bailouts and other fiscal policy measures many are now questioning the impacts on the future value of the US dollar. In an ironic twist, should the local and global economy start to show signs of real improvement, the US dollar will most likely plummet as the “safety” trade unwinds. Case in point, as the stock market jumped 20% over the last 2 weeks on possible signs of a recovery, the dollar index (DXY), a measure of the greenback strength against a trade-weighted basket of six major currencies, dropped by over 10%.

There is not much do in the short term – the US dollar/debt is the only game in town for now, with few alternatives other than gold. But longer term and if you are mainly an equity investor you need to factor in that the fall of the US dollar is more likely than not. Unfortunately, the lower US dollar will also drive inflation domestically and reduce our consumer and corporate purchasing power. No one knows currency movements for sure, but your best bet is to ensure you have significant international diversification in your retirement and trading portfolio’s.

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