Fish a U.S. dollar out of your wallet and lay it out on your palm. Does it feel lighter than it did last spring?
Between early March and late November 2009, the value of the U.S. dollar, relative to a collection of six overseas currencies, sank 16%. Perhaps more importantly, the depreciation was a sizeable factor in a 37% rise in the average price of a gallon of regular gasoline over the same period.
“A weaker U.S. dollar leads to a stealth reduction in its buying power,” says Paul Kasriel, Northern Trust’s chief economist. “Essentially, U.S. consumers must give up more dollars than when the currency was stronger to get the same amount in return.”
Under the simplest definition, the value of the U.S. dollar hinges on basic economic supply and demand. As supply oversteps demand, investors will offer smaller amounts of foreign currencies for the dollar, diminishing its value. Conversely, when demand outstrips supply, investors bid the dollar higher and other currencies depreciate.
As is the case with most elements of the global financial system, however, assessing the U.S. dollar’s relative value is anything but simple. Many other related factors, such as international interest rates, quality issues and economic expectations, also weigh into the supply/demand equation.
Declining Demand for the U.S. Dollar
Starting in early March 2009, investor demand for the U.S. dollar drifted lower as confidence took root that the world’s economy had avoided a second Great Depression. The decline renewed a trend that emerged as the U.S. economy weakened in 2008, but was suspended late that year as the global financial market teetered on the edge of collapse.
In times of crisis, the U.S. dollar remains a beacon of security for investors. Yet its low-risk profile is generally deemed too conservative once it appears safe to wade back into assets offering potentially higher returns.
Last spring, with the global financial system seemingly on firm footing, many investors exited dollar positions. Meanwhile, currency specialists zeroed in on the U.S. economy, and they weren’t exactly enthralled, according to James Hamilton, a professor of economics at the University of California, San Diego.
One upside to a depreciating dollar is that U.S.-produced goods are more attractively priced in overseas markets, which can lead to increased production and a reduced trade deficit.
“The general perception was that the rest of the world was recovering faster than the U.S. from the recession,” Hamilton says. “At the same time, the U.S. had greatly expanded its debt, and other countries didn’t cut interest rates as low as the Federal Reserve, so bonds issued by other countries offered more attractive returns.”
Since government debt must be purchased with that country’s currency, demand for U.S. dollars waned on the international stage as investors steered toward better yields offered on bonds issued by Australia and emerging market Brazil, among others.
And Then There’s China
Regardless of traders’ short-term perspectives on the U.S. dollar, it remains the reserve currency of the world — the standard by which the bulk of global currencies are measured and most commodities are priced. Such status reflects international confidence in the U.S. government, which is well regarded for its stability and ability to pay off its debts.
That said, the amount of debt issued by the U.S. Treasury — $1.8 trillion in the fiscal year that ended September 30 and a projected $2.4 trillion for the current fiscal year — has some creditors worried. Most notably, the Chinese government, which held nearly $800 billion of Treasury issues at the end of September, has openly questioned the validity of the dollar standard.
In an environment where the U.S. dollar is sagging, major overseas currencies are climbing and commodities command higher prices, Paul Kasriel, Northern Trust’s chief economist, says the following investments tend to lead the market for U.S. investors:
- Bonds issued in appreciating currencies;
- Stock in foreign companies that report earnings in appreciating currencies;
- Stock in U.S.-based multinational companies that have overseas operations;
- Stock in U.S.-based companies that generate significant revenues from exports; and
- Commodities, most notably gold, which tends to be very sensitive to currency markets.
“Obviously, China is worried about the future purchasing power of its dollar holdings,” Kasriel says. “But it’s a symbiotic relationship, as the country has chosen to export large volumes of goods to the United States, for which it receives billions of U.S. dollars and it chooses to invest many of those dollars in Treasuries.”
According to Hamilton, a government’s actions offer deeper insights than its words, and he finds it interesting that the Chinese government has stockpiled large quantities of commodities, which tend to rise as the dollar declines. Elsewhere, central banks in India and Russia added considerably to gold positions in the fall, boosting exposure to a metal considered by many to be a hedge against all currencies.
The Federal Reserve and Debt Monetization
While the demand dynamic for the U.S. dollar became increasingly delicate in 2009, supply side issues flared up as well.
The nation’s money supply is controlled by the Federal Reserve, which played a key role in furnishing liquidity — or ensuring an ample supply of cash — to the troubled banking industry during late 2008 and early 2009. While many praised its response to the crippled financial markets, thoughts quickly turned to how the Fed planned to mop up the liquidity — or remove the excess cash from the system — once all was deemed healthy.
Separately, wariness grew over potential plans for a process known as debt monetization, where the Fed purchases debt issued by the Treasury. The maneuver helps prop up demand for Treasury issues, which tames interest rates, but increases the amount of available cash. Again turning to the law of supply and demand, too many dollars in the system can reduce the value of the currency, which usually leads to inflation that translates into even higher dollar-denominated prices for goods and services.
“Monetizing the debt is nothing new,” says Arturo Estrella, the head of the economics department at Rensselaer Polytechnic Institute in Troy, N.Y. “But one concern about current conditions is that the amount of additional debt the Treasury will need to issue is so huge that we might be looking at a different situation than we’ve seen before.”
How to Shore Up the U.S. Dollar
One upside to a depreciating dollar is that U.S.-produced goods are more attractively priced in overseas markets, which can lead to increased production and a reduced trade deficit. Nonetheless, its weakness is a leading worry in Washington, as evidenced by Fed Chairman Ben Bernanke’s mid-November declaration that the central bank’s policies are designed to help support a strong dollar. His comments came shortly after Treasury Secretary Timothy Geithner publicly stressed that it was “very important” for the United States to maintain a strong dollar.
“Officials typically don’t like depreciation because it could be seen as a loss of confidence in the U.S. government,” Estrella says.
Aside from the high-level posturing, which extends a long tradition of public statements from administration officials that have little impact on the markets, Kasriel says sustainable strength in the dollar stems from a healthy U.S. economy. More specifically, he says the world would want to see:
- Higher U.S. interest rates, relative to inflation;
- A reduced rate of growth in U.S. government spending;
- Relatively low U.S. tax rates, especially on businesses; and
- A relatively small amount of U.S. regulation.
But unless — or until — all of those elements align, figure on spending more of those lighter dollars nestled in your wallet.