What happens if the US dollar falls?

Posted by on April 7, 2009 in Investment Products

Last month, China publicly mused about creating a currency alternative to the U.S. Dollar (USD). This was a pretty significant statement since, unlike other countries who have proposed the same in years past, China is the largest purchaser of U.S. Treasuries (i.e. U.S. government debt). The statement was widely interpreted as growing disenchantment with the long term ability of the U.S. government to manage its financial house properly or, more ominously, pay back its debt-holders (the Chinese government rarely publicly rebukes a foreign government so when it does, it is saying something).

Notwithstanding a short-term rise in the USD, many predict that the USD will eventually weaken against other currencies for a variety of reasons (trillion dollar deficits, large trade deficits and inflation being three primary ones). What happens to the average investor if the USD begins to fall?

  1. The price of gold rises. Gold is seen as a hedge against currency depreciation, viewed as being the only “pure” currency around by many (if you are truly worried about inflation and the falling USD, the recent drop in the price of gold may be a good entry point- big ifs, so do your due diligence).
  2. Commodity prices rise. The theory is that a falling USD works lock-step with rising inflation. As the value of money decreases, it costs more to purchase a finite asset. Thus, commodity prices increase as inflation increases. If you believe this scenario, an ETF tracking a commodities index or a stock exchange overweight in oil/gas/commodities stocks may be appropriate (i.e. the TSX).
  3. Interest rates will go up. In order to entice foreign countries to continue to purchase a falling currency, interest rates have to increase to compensate for higher risk. In other words, our low interest variable rate mortgages may be a short term reward only. For a recent example, one of the reasons’s why Canada’s recovery from the 1991 recession was significantly slower than the U.S. was because the Bank of Canada had to keep the prime rate higher as a means to help the continual sale of Canadian debt; without a cheap supply of money, it was harder for Canadian businesses to expand quickly. If interest rates do rise, a portfolio overweight in fixed income may not be appropriate and it may be better to lock in your mortgage rate.

If the USD does fall and the government cannot rein in its spending, in some respects, the U.S. may have a recovery similar to Canada’s in the 1990′s; a country massively in debt tries to pay off its debt while enticing governments to buy their debt by cutting back the size of government and keeping interest rates high at the cost of putting public sector workers on the unemployment roles and choking off a cheap supply of capital to business as government debt and relatively high interest rates has a crowding effect on private enterprise.

As I blogged before, it took Canada 10 years to recover from the 1991 recession. If the falling USD scenario does play out, it does give credence to fund managers who are taking positions in commodities not because of some fatalistic end of world reason but based on larger macro economic trends.

8 Comments on What happens if the US dollar falls?

By Million Dollar Journey on April 7, 2009 at 7:01 am

Hey TWM, great article and thanks for the link. I think that your argument is spot on. With the recent market rally, I have been tempted to sell off some of my commodity shares. However, with inflation around the corner, I’m holding onto them to rise with inflation.

By Geoff on April 7, 2009 at 2:26 pm

I think there is a shift toward real assets. For instance:

1) All over the world, mints can’t handle the demand for gold coins.
2) Most people are not buying gold.
3) Over the long haul, gold prices have preceded commodity prices
4) Gold was the best investment choice for 2008
5) Gold is below its inflation-adjusted high.
6) Unlike its paper-based counterpart, physical gold is no one’s liability.
7) Ascendant governments such as China are buying more gold.
8) All the nations of the world are debasing their currencies by printing more of it. We can’t print more gold, wheat, or sugar, etc..

By admin on April 7, 2009 at 4:55 pm

Geoff- there’s a real push/pull with gold for me; a great inflation hedge but is there any intrinsic value to it? I tend to look at it for safety even though there may or may not be real value in the asset itself. At least with copper, you can use it for telco. Silver has industrial applications etc. etc.

By Lance on April 7, 2009 at 9:02 pm

Gold’s strongest asset is that it is the most sought after as a store of wealth. It has some attributes that make it a good candidate for this role: limited new supply available, doesn’t tarnish/rust, has a high value/weight ratio, etc. In some respects, silver is a better choice because of its industrial uses, but you have to store a lot more silver than you do gold to hold the same amount of value.
An item often overlooked as a wise inflation hedge for the coming storm is oil… especially if you are a peak oil believer. Oil is a commodity that all nations desire greatly, cannot easily switch away from, has ever an increasing demand with limited and declining supply. This is a recipe for a possible oil crisis like none we have seen before… it may make $145 oil look like a bargain. And given that oil is used in virtually every manufacturing operation as an energy source and/or a primary input, higher oil prices create more inflation which thus drives up the price of oil even more.

Forget gold, my money’s on oil as the investment place to be over the next 5 years.

By Canadian Finance on April 7, 2009 at 11:21 pm

I’m actually rather surprised that the US dollar hasn’t fallen much yet. I think it will happen eventually, and mortgage rates will rise. I just signed a 5yr fixed for 4.05%, I’m sure in 2-4 years I’ll be happy I did!

By Friday Links | The Canadian Finance Blog on April 10, 2009 at 6:07 am

[...] Thicken My Wallet gives us some insight on what will happen if the US dollar falls. [...]

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By Chris on November 23, 2009 at 6:46 pm

Some good points there. As a history buff, i find it interesting that nations repeat many of the same mistakes even when done recently,( Russia in Afghanistan 1980-1990)and they were sent home poorer with their tail between their legs.
In these times I think its important to watch carefully what’s happening in the world, not just in our backyards and adjust our our investments and spending accordingly and even what job to hold or switch to. As a tradesman, I find my work can’t be outsourced and even with competition from illegals, giving good service and top quality workmanship serves me well. Regardless of the economy there are always people with money and people making it one way or another.

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