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Guarding against a dollar fall, 1 of 2: the situation. [ClearOnMoney]
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Guarding against a dollar fall, 1 of 2: the situation.

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Commentary

Guarding against a dollar fall, 1 of 2: the situation.

17 Nov 2009 by Jim Fickett.

Many people are worried about the future value of the dollar, both domestically and in exchange for other currencies. There are good reasons to worry, and one's decisions in this area could very well turn out to be absolutely key to returns over the coming years. However there is also a great deal of uncertainty in the likely course of events. In this and a later post I give a very broad-brush, and very personal, overview of driving forces, as well as advantages and disadvantages of some possible portfolio choices, by way of providing a context for more specific future points.

Many people, from US retirees with their savings in dollars, to the Chinese government, with much of its reserves in dollars, are worried about the dollar losing value. The Economist wrote (Chucking the buck, subscription required) on p86 of the 26 Sep issue:

It is hard to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little attempt to control, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down and a new currency system will come into being, just as Bretton Woods emerged in the 1940s.

I am worried, and regard the trend in the dollar's value over the next decade or two to be one of the top three or four most important investment trends of our time. In what follows I will set out a very broad, and very personal, view of both the situation and some possible responses. I will make no attempt to provide extensive evidence, since these two articles are more an attempt to paint a context than an argument to support a particular point or conclusion.

It is probably wrong to try to forecast a particular time course of events. There is a great deal of argument currently over future exchange rate moves, and about the danger, or not, of inflation. There are plausible arguments that lead to different conclusions. In my view, one should, in such a situation, try to picture a course of events that seems most likely, given one's own view of all the evidence, but also to keep in mind the various ways in which one might be wrong. A few things stand out about the current situation:

  • There is a lack of political will to face the deficit problem. Yes, I understand the country is still in crisis mode. But projected deficits remain very high much farther into the future than the crisis is expected to last, and while there is a great deal of talk about getting our fiscal house in order, this is not the first time there has been talk without serious action. My conclusion is that deficits are likely to remain out of control for a long time, not because there is no way to tame them, but because it is not a priority to tame them. This could change, of course, but probably not quickly.
  • Many high-profile investors, and many nations, have made it clear they want to diversify out of dollars. Most likely this will continue at a gradual pace. As long as China emphasizes an export economy and keeps the yuan pegged to the dollar, they cannot move very fast on diversifying, much as they state their desire to do so. And the largest players realize that sudden moves could cause a panic, and will proceed slowly. There is a very small chance that some sudden move could start a panic, with everyone trying to sell dollars at once.
  • Longer-term interest rates are likely to rise. The Fed's purchases of long-dated bonds and mortgage securities are mostly done, the Treasury is borrowing record amounts, and people are worried about the dollar. Of course traders drive a large part of the market, and the value of long-dated bonds has as much to do with whether short-term traders expect an immediate change, as it does with a real estimate of value. So it is very hard to predict when interest rates will rise. My own guess is that sometime within a year there will be some event that suddenly changes sentiment, like insufficient take-up on a Japanese bond issue, oil prices starting to drive inflation higher again, or the end of the Fed purchase program.
  • The Fed will be tempted to monetize debt. It is often pointed out that deficits are not inherently inflationary; it depends on whether they are funded by borrowing or by printing. The reality of politics is that large deficits have, historically, often been reduced by default or inflation, and the actions of the Federal Reserve in this crisis have seriously compromised its independence. Although the higher long-term rates I expect could help stabilize the dollar exchange rate, they would also endanger an economic recovery that will still likely be fragile. If it comes down to the choice between high interest rates that might precipitate another serious recession, or monetizing the debt and allowing some inflation, the Fed might well be tempted by the latter.
  • Higher inflation may become accepted policy. Many economists are in fact calling for a somewhat higher rate of inflation than the usual 1-2% target, saying that the only way out of excessive debt, for many individuals and institutions, is to inflate some of it away.
  • Protectionism, of which one form is a declining currency, is a political reality. There is a mid-term election in 2010, and politicians very much want to demonstrate progress in economic recovery. One way to do that would be to boost exports via a declining dollar. For this reason few take Mr Geithner's protestations about a strong dollar policy seriously.

Many of the above points are quite soft and difficult to quantify. Yet, taken together they make a fairly persuasive case that, at the least, there are significant risks. All in all, I think the most likely outcome on exchange is a gradually worsening rate, though it is quite possible the dollar could either fail to drop or drop quickly. On inflation, I think unrealistic attitudes and lack of political will are deeply ingrained, and that fairly serious inflation is quite likely. The most difficult question for the investor, regarding inflation, is timing. My best guess is that in 2010, as the effects of various stimulus efforts wear off, recovery will wane, and with it inflation expectations, so that we won't see serious inflation for a few years.

The main conclusions, then, is one that is fairly common today: there is probably little risk in a collapse of the value of the dollar, and almost no risk of immediate inflation, yet in the longer term the dollar is quite likely to lose significant value, and one should protect one's portfolio. In the second post I'll address advantages and disadvantages of some ways to do that.