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 when compared to other currencies in the foreign exchange market. That means the dollar index falls. It also means the euro to dollar conversion is higher since 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 usually means a stronger yen.

 

A declining dollar can also mean that the value of U.S. Treasuries falls. This drives up Treasury yields, and therefore interest rates. For more, see What Is the Relationship Between Treasury Notes and Mortgage Rates?

It can also mean that foreign central banks and sovereign wealth funds are holding fewer dollars, thereby lowering 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. A weaker dollar will also drive up oil prices, since oil and many other foreign contracts are denominated in dollars, and oil-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, since their goods seem cheaper to foreigners.

This boosts U.S. economic growth, thus attracting foreign investors to U.S. stocks. However, 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, FATCA (the Foreign Account Tax Compliance Act) required foreign banks and other financial institutions to disclose information about income and assets held by U.S.

customers. Its goal is to root out wealthy U.S. taxpayers that are deliberately hiding money offshore. It also wants to stop foreign banks who are using tax evasion as a profitable line of business. Many were worried that 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 makes London the first trading hub for the yuan outside of Asia. This is one more way that China is trying to encourage central banks to increase their holdings of Chinese yuan. This 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. That's because the world's third largest economy is worried that its economy is growing too slowing. However, trouble in 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 lower point in 200 years on June 7, 2012.

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

Background

The dollar declined 40 percent between 2002-2008, partly because of the (at that time) $700 billion U.S. current account deficit. 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 relatively safe haven. In March 2009, the dollar resumed its decline.

That's thanks to the (now) $19 trillion U.S. debt. Creditor nations, like China and Japan, worry that the U.S. government won't really support the value of a dollar. Why not? A weaker dollar means that the deficit will not cost the government as much to pay back. Creditors have been gradually changing their assets to other currencies to stem their losses. Many fear that this could turn into a run on the dollar. That's what would quickly erode the value of your U.S. investments and drive inflation.

How to Protect Yourself From a Declining Dollar

The steps you take to protect yourself from inflation also protect you from a dollar decline. The best way, of course, is to increase your earning potential through education and training. You should also invest part of your portfolio in the stock market. Even though it's risky, the risk-adjusted returns usually outpace inflation. You can also purchase Treasury Inflated Protected Securities and Series I Bonds from the U.S. Treasury. For more, see How Can I Protect Myself from Inflation?

You can also purchase euros, yen or other currencies that will rise 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 value. 

If the dollar falls faster, prompting hyperinflation, then you would benefit from buying gold, precious metals and shares in gold mining companies. This the recommendation of The Coming Collapse of the Dollar. However, the authors also recommend short-selling stocks of companies that will be hurt by a falling dollar. That's not a good idea because a) you don't really know which companies will be hurt the most and b) you don't know how fast the dollar will fall. If you did, you'd be better off buying foreign currency futures contracts that would use leverage to reward you for that knowledge. 

If the dollar absolutely collapses, the devastation upon the world's economy would be hard to imagine. Since no one really knows what would happen, you must be ready to move at a moment's notice. 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, like cooking, farming or repairs. Get a passport, in case you need to move to another country.

Of course, the best defense against any uncertain future is 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