What happens if the US dollar falls?
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?
- 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).
- 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).
- 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.