Why the Falling U.S. Dollar Is Just a Hint of What's to Come

It's been a wild year for the greenback. While the falling U.S. dollar of last week can be blamed on the U.S. Federal Reserve's surprise decision not to taper its bond buying, for most of the past two years, the dollar has been rising.

In fact, before the FOMC meeting last week, the dollar was up 12% since mid-2011.

And yet while the factors contributing to a rising U.S. dollar are likely to continue for a while, investors also need to be aware of several long-term threats to the dollar that eventually will fatally weaken the currency.

It's important for investors to understand exactly why the dollar is falling at times and rising at others, because the strength of the currency affects virtually every investment in one way or another.

Here's a piece-by-piece look at what's been going on this year with the dollar, and what investors can do to profit from it.

The Falling U.S. Dollar: A Reaction to the Fed

Most experts (with this very notable exception) had assumed the Fed would announce a start to the quantitative easing (QE) taper, a reduction of about $10 billion from its $85 billion a month of bond buying.

That would have been helped strengthen the dollar by reducing some of the liquidity that the Fed has been pumping into the U.S. economy. When the Fed instead stood pat, the currency markets reacted negatively. The dollar index fell 1%, to 80.060, a seven-month low, the day of the Fed announcement.

That excess Fed liquidity - the central bank has added $3 trillion to its balance sheet since the 2008 financial crisis - is actually one of the long-term threats to the U.S. dollar, as we'll see shortly.

The falling U.S. dollar reaction to last week's Fed decision, however, will be short-lived.

Before long, we'll return to a rising U.S. dollar, at least for a while.

Here's why it's inevitable that the dollar will soon resume its upward trajectory...

Why We'll See a Rising U.S. Dollar

One of the biggest reasons a rising U.S. dollar is in our future is because the nation has a clean track record of making good on its debts.

"The U.S. has never defaulted," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "The world may hate our guts, but when all hell breaks loose, they all love our dollar."

Meanwhile, virtually every major central bank in the world has adopted the same easy money - and currency-debasing - policies as the U.S. Federal Reserve.

That, and the fact that the dollar remains the world's reserve currency (the currency used by all nations to buy commodities), makes the U.S. dollar "the best-looking horse in the glue factory," Fitz-Gerald said.

But there's one more recent wrinkle to the dollar's situation that has helped make it stronger against other major currencies.

It's the U.S. shale oil boom.

For decades, the United States has imported a great deal of oil and has paid for that oil in dollars. That money is used by other nations to pay off debts and buy commodities denominated in U.S. dollars.

But the shale oil boom has reversed the trend. The United States has begun to cut back on oil imports as domestic production increases.

That, in turn, is reducing the number of U.S. dollars flowing out into the global economy, creating a shortage of dollars and pushing its value higher.

"An asset like oil collateralizes the currency itself," Fitz-Gerald said. In other words, with some real asset to back at least some of it - in this case, oil - U.S. dollars are more valuable relative to other fiat currencies like the euro and the Japanese yen.

But even these advantages won't be enough to overcome the rot in the foundation of U.S. fiscal policy that eventually will doom the dollar.

Why the U.S. Dollar Is Doomed

Decades of irresponsible behavior by the government will eventually bring a falling U.S. dollar. In fact, bad policies have already dinged the dollar's value against other major currencies by 50% over the past 28 years.

  • The Fed's money printing: The trillions the Federal Reserve has created as a result of its quantitative easing represent perhaps the biggest threat to the dollar. We haven't yet witnessed the damage of QE because much of the money is sitting quietly in the reserves of the big banks. But when they decide to unleash all those dollars, we'll get massive inflation.
  • Loss of reserve currency status: One of the great props to the U.S. dollar is its status as the world's reserve currency, but the Fed's actions and a desire for a less U.S.-centric global economy mean the world has started to consider alternatives. Even if not completely replaced, the dollar will at least have competition - most likely in the form of the Chinese yuan.
  • Unfunded liabilities: Forget the $17 trillion of debt the federal government owes. Fitz-Gerald is more worried about Washington's $222 trillion of unfunded liabilities. That includes the true cost of future Social Security and Medicare payments, as well as interest on the national debt. The need to pay for this is a strong incentive to further debase the dollar, that is, print more of it to pay off the debts, which in turn reduces that value of all existing dollars.
  • The derivatives time bomb: The big banks like to make big bets. If the bets work out, they rake in billions; if not, the government will bail them out with billions. But there are $1.2 quadrillion worth of derivatives out there, far more than the global gross domestic product of $71.8 trillion. And it's leveraged anywhere from 10-to-1 to 50-to-1. When it blows up it will destroy the entire global financial system in a way that will make the 2008 financial crisis look like a rounding error.

"They've created this hydra around the U.S. dollar," Fitz-Gerald said. "All of it has to come home to roost at some point; we just don't know when."

What Investors Should Do Now

Fitz-Gerald says that while investors need to stay vigilant regarding the fate of the U.S. dollar, for now they should try to protect themselves while wringing what profit they can from the rising U.S. dollar.

That means investing in multinational companies, which are less vulnerable to the dollar's gyrations because they have a lot of exposure to foreign currencies. They also have exposure to the growth of emerging markets.

And a rising U.S. dollar means it's smart to be in dollar-denominated investments - but with protective stops just in case.

For several other moves investors should make to prepare for a falling U.S. dollar, Money Morning has prepared a special report - which you can get free here.

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