Commentary - Dollar Weakness Could Be Way of Life for Years

A panel of currency strategists recently discussed the future of the US dollar and for those holding the greenback, the news was rather grim. The panel believed unanimously that the dollar is likely to experience sustained weakness as the global recovery gathers steam. In fact, it will be the recovery itself that will lead to this devaluation.

On the surface, it may seem illogical that just as the economy begins to recover, the dollar should weaken, but this has everything to do with demand, and as we shall discover, demand for the dollar could actually decrease as the economy picks up. This is because during the economic crisis, investors and even national banks, turned to the US dollar as a “safe haven” play. In other words, as stocks and other securities faltered, and even as other currencies shed their value, money was “parked” in the greenback in a ploy designed to preserve wealth as markets came crashing down.

Meanwhile, the Federal Reserve slashed interest rates to encourage consumer spending, while the government busied itself with a series of quantitative easing programs in an attempt to prevent the deepest recession since World War II from transforming into a full-blown depression. The result? Well, the recession appears to be slowly waning, but the fiscal deficit has been pumped up by another two trillion dollars to around $12 trillion and the national lending rate is effectively zero percent. As a result, short-term yield rates have fallen and investors around the world are now questioning the wisdom of holding on to their US cash if the worst of the recession is indeed behind us.

While moving to short-term, dollar-denominated securities made a great deal of sense as the economic storm clouds were gathering, now that growth appears to be returning to the major economies once again, this hedge is now past its prime and investors want higher yields than the measly returns generated with T-bills and cash accounts.

The first wave of investors to unwind these positions will likely be institutional investors including large hedge funds chasing after higher returns in the equity markets. This sudden flood of dollars will result in downward pressure on the dollar, and if it appears that the dollar is headed for a significant loss, could trigger foreign central banks to also divest themselves of at least some of their dollars. This is a distinct possibility as China in particular has threatened for some time now to reduce its dollar holdings and this would be disastrous for the greenback.

Top Three Holders of US Debt as of June 2009

1. China - $776 billion
2. Japan - $711 billion
3. United Kingdom - $214 billion

Normally, the first course of action to protect the value of a currency and boost its popularity, is to increase interest rates, but this option is not available to the Fed; any interest rate increase in lending rates would surely kill the fledgling recovery. This is the very scenario that prominent economist Nouriel Roubini has warned could lead to a “double-dip recession”.

Now, it would be naïve to think that the US dollar is going to cease altogether being the currency of choice for currency reserves. More likely, one or more of the top lending countries will opt to reduce their overall exposure to the dollar, but this alone could lead to a cascading effect whereby less demand weakens the dollar, and each devaluation results in even less demand for the buck. This cycle of falling demand and subsequent devaluations could continue until the US economy recovers to the point where the Fed is able to introduce interest rate hikes.