The U.S. dollar declines when the dollar's value is lower compared to other currencies in the foreign exchange market. This manifests itself as a decline in the dollar index. Generally, this means a foreign currency, such as the euro, can buy an increasingly large amount of dollars.
A declining dollar can also mean a fall in the value of U.S. Treasurys. This drives up Treasury yields and interest rates. Treasury note yields are the main driver of mortgage rates. It can mean that foreign central banks and sovereign wealth funds are holding fewer dollars, too. This lowers the demand for dollars.
A weaker dollar buys less in foreign goods. This increases the price of imports, contributing to inflation. As the dollar weakens, investors in the benchmark 10-year Treasury and other bonds sell their dollar-denominated holdings.
Contracts for oil and other commodities are usually denominated in dollars. As a result, historically, there has been an inverse relationship between the value of the dollar and commodities prices. Essentially, as the value of the dollar falls, the dollar-denominated prices of these commodities must rise to reflect their unchanged intrinsic value.
On the plus side, a weakening dollar helps U.S. exporters. Their goods will seem cheaper to foreigners. This boosts the United States’ economic growth, which attracts foreign investors to U.S. stocks. However, if enough investors leave the dollar for other currencies, this could cause a dollar collapse. This is largely a theoretical consideration. The probability of this development is extremely low, as discussed in the closing section of this piece.
In 2010, 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. China would like the yuan to replace the dollar as the world's reserve currency.
Since then, China has been devaluing the yuan against the dollar. It is doing so because its leaders are worried the economy is growing too slowly. The devaluation objective is largely accomplished via the continual purchase of U.S. dollars by the Chinese central bank. Clearly, China’s actions have a significant impact on the value of the dollar.
The dollar declined 40% between 2002 and 2008. This was in part because of the $702 billion U.S. current account deficit at the time. Over half of the current account deficit is owed to foreign countries and hedge funds.
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 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.
7 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.
- Increase your earning potential through education and training. If you earn more each year, you can outpace a dollar decline.
- Invest part of your portfolio in the stock market. Even though it's risky, the risk-adjusted returns often outpace inflation.
- Purchase Treasury Inflated Protected Securities and Series I Bonds from the U.S. Department of the Treasury. These are two sound ways to protect yourself from inflation.
- 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 that tracks their values.
Some experts recommend short-selling stocks of companies that will be hurt by a falling dollar, but this isn’t a good idea for everyday investors. It is extremely difficult to predict which companies will be adversely affected, given all of the other variables at play. Moreover, it is difficult to predict when and how fast the dollar will fall, if it experiences downward pressure.
- Buy gold, precious metals, and shares in gold mining companies. If the dollar falls faster, prompting hyperinflation, then you would benefit.
- If you’re worried about it, then take this sixth step. Keep your assets liquid, so you can buy and sell as needed. In this scenario, you should have as little as possible in real estate, gold bullion, 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.
- 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 Some Say the Dollar Could Collapse
Some say the euro could replace the dollar as an international currency. They point to the increase in euros held in foreign government reserves. Between the first quarter of 2008 and the first quarter of 2020, the holdings of euros almost doubled from $1.16 trillion to $2.19 trillion.
But the facts don't support that theory. At the same time, U.S. dollar holdings more than doubled, from $2.7 trillion to $6.7 trillion. Dollar holdings are 61.99% of the $11 trillion of total measurable reserves. That's only slightly less than the 62.94% held in Q1 2008. The International Monetary Fund provides details about foreign exchange reserves for each quarter with the COFER Table.
China is the second-largest foreign investor in dollars. As of June 2020, it held $1.07 trillion in U.S. Treasury securities. China periodically hints it will reduce its holdings if the U.S. doesn't reduce its debt. Instead, its holdings continue to increase. The U.S. debt to China was 15% of America's debt to foreign countries.
Japan is the largest investor with $1.26 trillion in holdings. It buys Treasurys to keep the value of the yen low, so it can export more cheaply. Its debt is 196% of its gross domestic product.
Why the Dollar Won't Collapse
Many say the dollar won't collapse for four reasons. First, it's backed by the U.S. government. That makes it the premier global currency. Second, it's the universal medium of exchange. That's thanks to its sophisticated financial markets. The third reason is that most international contracts are priced in dollars.
The fourth reason is probably the most important. The United States is the world's best customer. It's the largest export market for many countries. Most of those countries have either adopted the dollar as their own currency. Others peg their own currency to the dollar. As a result, they have zero incentive to switch to another currency.
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. Its products become more competitive. In fact, the decline in the dollar helped to improve the U.S. trade deficit in 2012.
Although the dollar has declined dramatically over the last 10 years, it has never been in danger of collapsing. It's not in the best interest of most countries to allow this to happen. A collapse would wipe out the value of their dollar holdings.
Regardless of the anticipated direction of the dollar, most experts agree that the best hedge against risk is to maintain a well-diversified investment portfolio. Ask your financial planner about including overseas funds. These are denominated in foreign currencies, which rise when the dollar falls. Focus on economies with strong domestic markets. Also, ask about commodities funds, such as gold, silver, and oil, which tend to increase when the dollar declines.