A declining dollar can also mean a fall in the value of U.S. Treasurys, which 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.
Economic Effects of a Declining Dollar
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 international buyers. 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.
Potential Causes of Dollar Decline
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. Another aim of the law is to stop foreign banks from using tax evasion as a profitable line of business. Many people were worried that foreign banks would drop U.S. customers, to avoid compliance with the law, thereby pushing those banks away from dollar-denominated assets, which might lead to a decline in the dollar’s value. 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. Were that to happen, the dollar would lose value. Since then, China has been devaluing the yuan against the dollar. It is doing so because its leaders are worried China’s 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.
Recent Declines in the Dollar’s Value
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, worried that the U.S. government wouldn’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:
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 fourth quarter of 2021, the holdings of euros more than doubled, from $1.16 trillion to $2.49 trillion. But the facts don’t support that theory. At the same time, U.S. dollar holdings nearly tripled, from $2.7 trillion to $7.1 trillion. Dollar holdings are 58% of the $12 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 March 2022, it held $1.04 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. Japan is the largest investor with $1.23 trillion in holdings. It buys Treasurys to keep the value of the yen low, so it can export more cheaply. Its debt is 193% 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 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.
The Bottom Line
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 that 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.
