Dollar Decline or Dollar Collapse?

A Dollar Decline Is Inevitable, While a Collapse Is Unimaginable

dollars in a whirlpool
A dollar collapse would destroy the dollar's value like a whirlpool. Photo: Piotr Powietrzynski/Getty Images

Definition: The U.S. dollar declines when the dollar value is lower compared to other currencies in the foreign exchange market. It means the dollar index falls. It also means the euro to dollar conversion is higher because euros get stronger and can buy more dollars when the U.S. currency weakens. It could also threaten the yen carry trade because a weaker dollar often means a stronger yen. 

A declining dollar can also mean a fall in the value of U.S. Treasurys.

This drives up Treasury yields and therefore, interest rates. For more, see What Is the Relationship Between Treasury Notes and Mortgage Rates?

It can mean that foreign central banks and sovereign wealth funds are holding fewer dollars too. This lowers the demand for dollars. For more, see 3 Ways the Dollar's Value Is Measured.

Effects

A weaker dollar buys less in foreign goods. This increases the price for imports, contributing to inflation. As the dollar weakens, investors in the benchmark 10-year Treasury and other bonds sell their dollar-denominated holdings. Oil and other foreign contracts are denominated in dollars. A weaker dollar will drive up their prices because the exporting countries need to maintain their profit margins.  For more, see 3 Factors That Determine Oil Prices.

On the plus side, a weakening dollar helps U.S. exports. Their goods will seem cheaper to foreigners. This boosts the United States’ economic growth, which attracts foreign investors to U.S. stocks.

 But, if enough investors leave the dollar for other currencies, it could cause a dollar collapse. For more on this, see Dollar Collapse: Causes, Impact, and When It Would Happen.

Causes 

On July 1, 2014, the Foreign Account Tax Compliance Act required foreign banks and other financial institutions to disclose information regarding income and assets held by U.S.

customers. Its goal is to root out wealthy U.S. taxpayers who are hiding money offshore on purpose. It also wants to stop foreign banks from using tax evasion as a profitable line of business. Many were worried foreign banks will drop U.S. customers, to avoid compliance, thereby pushing them away from dollar-denominated assets. 

On October 16, 2013, China allowed British investors to pour $13.1 billion into its tightly restricted capital markets. This made London the first trading hub for the yuan outside of Asia. This is one way China is trying to encourage central banks to increase their holdings of the Chinese yuan. It is the biggest potential threat to the value of the dollar. For more, see Is the Yuan Replacing the Dollar as the World's Reserve Currency.

Since then, China has been devaluing the yuan against the dollar. It is doing so because the world's third largest economy is worried its economy’s growth is too slow.  But the trouble is China would strengthen, not weaken, the dollar because the Chinese central bank buys dollars to keep it strong and the yuan weak. For more, see How Does China Influence the U.S. Dollar?

The yield on the 10-year Treasury note hit its lowest point in 200 years on June 7, 2012.

It indicated dollar strength as measured by Treasurys. China's currency, the yuan, rose to 6.4167 against the dollar, a 17-year high, on August 10, 2011. It showed further dollar weakness as a result of the debt ceiling crisis.

Background

The dollar declined 40 percent between 2002 and2008. This was in part because of the $700 billion U.S. current account deficit at the time. Over half of the current account deficit is owed to foreign countries and hedge funds. (Source: U.S. Treasury Dept.) 

The dollar strengthened during the recession, as investors sought a safe haven in comparison to other currencies. In March 2009, the dollar resumed its decline thanks to the now $19 trillion U.S. debt. Creditor nations, like China and Japan, worry the U.S. government won't support the value of a dollar. Why not?

A weaker dollar means the deficit will not cost the government as much to pay back. Creditors have been changing their assets to other currencies over time to stem their losses. Many fear this could turn into a run on the dollar. That would erode the value of your U.S. investments fast and drive inflation.

Seven Steps That Will Protect You from a Declining Dollar

There are seven steps you can take to protect yourself from inflation and a dollar decline. First, increase your earning potential through education and training. If you earn more each year, you can outpace a dollar decline.

Second, invest part of your portfolio in the stock market. Even though it's risky, the risk-adjusted returns often outpace inflation. Third, purchase Treasury Inflated Protected Securities and Series I Bonds from the U.S. Treasury. For more on these, see How Can I Protect Myself from Inflation?

Fourth, purchase euros, yen or other currencies which will increase in value if the dollar loses its power. You can either purchase them outright at a bank or buy an exchange-traded fund which tracks their values. 

If the dollar falls faster, prompting hyperinflation, then you would benefit from a fifth step. This involves buying gold, precious metals and shares in gold mining companies. Some experts recommend short-selling stocks of companies which will be hurt by a falling dollar. But that's not a good idea because you don't know which companies will be hurt the most. Furthermore, you don't know how fast the dollar will fall. If you did, you'd be better off buying foreign currency futures contracts. You could use leverage to better reward yourself for the knowledge. 

If the dollar outright collapses, the devastation upon the world's economy is hard to imagine. No one knows what would happen, so you must be ready to move at a moment's notice. If you’re worried about it, then take this sixth step. Keep your assets liquid, so you can buy and sell as needed. That means as little as possible in real estate, large volumes of physical gold, or other difficult-to-sell goods. Make sure you have skills that are needed everywhere, such as cooking, farming or repairing. Get a passport, in case you need to move to another country.

The seventh step is to make sure you have a well-diversified portfolio. Rebalance your asset allocation if it looks like the business cycle is going to shift. You can tell that by following key leading economic indicators.

Why the Dollar Could Collapse

The euro could replace the dollar as an international currency. Between Q1 2008 and Q2 2013 (most recent report), the value of euros held in foreign government reserves nearly tripled, from $393 billion to $1.45 trillion. At the same time, dollar holdings rose 36%, from $2.77 trillion to $3.76 trillion. Dollar holdings are 63% of the $6 trillion of total measurable reserves, down from 67% in Q3 2008.

This decline means that foreign governments are slowly moving their currency reserves out of dollars. (Source: IMF, COFER Table)

China is the largest investor in dollars. As of December 2012, it held $1.2 trillion in U.S. Treasury Securities. It periodically hints it will reduce its holdings if the U.S. doesn't reduce its debt. Here's an example - China May Reduce U.S. Debt. Instead, its holdings continue to increase. For updates, see What Is the U.S. Debt to China? 

Japan is the second largest investor, with $1.2 trillion in holdings. It buys Treasuries to keep the value of the yen low, so it can export more cheaply. However, its debt is now more than 200% of its GDP.

Oil-exporting countries (and the Caribbean banking centers that often serve as their front) hold $512 billion. If they decide to trade oil in euros instead of dollars, they would have less of a need to hold dollars to keep its value relatively higher.

For example, Iran and Venezuela have both proposed oil-trading markets denominated in euros instead of dollars.

Why the Dollar Won't Collapse

Many say the dollar won't collapse because

  1. It's backed by the U.S. Government, making it the world's safe harbor currency.
  2. It's the universal medium of exchange, thanks to our (still relatively) sophisticated financial markets.
  1. The major oil contracts are still priced in dollars.

Many in Congress want the dollar to decline because they believe it will help the U.S. economy. A weak dollar lowers the price of U.S. exports relative to foreign goods, making our products more competitive. In fact, the decline in the dollar helped to improve the U.S. Trade Deficit in 2012. 

Outcome

Although the dollar has declined dramatically over the last ten years, it has not yet created a collapse. It's not in the best interest of most countries to allow this to happen since it would decrease the value of their dollar holdings.

Regardless of the outcome, be prepared. Most experts agree that the best hedge against risk is with a well-diversified investment portfolio.

Ask your financial planner about including overseas funds. These are denominated in foreign currencies rise when the dollar falls. Focus on economies with strong domestic markets. Also, ask about commodities funds, such as gold, silver and oil, which increase when the dollar declines.  Article updated December 3, 2013