Arguments for a Long-Term Devaluation of the Dollar
Unless you’ve been living in a cave, you know that the dollar is losing its status as world reserve currency.

Many governments and international organizations are feverishly working to get away from the dollar into another reserve currency, or basket of reserve currencies.

Indeed, today’s rumor is that the Middle Eastern oil producers, plus China, Japan and France have all agreed to start trading oil using a basket of currencies – instead of the dollar – starting in 9 years.

Many investors plan on staying in the dollar as long as China is buying U.S. treasuries. No one wants to get out early, but no one wants to be left holding worthless monopoly money if and when China pulls the plug.

Many people – including me – try to read the tea leaves by monitoring the volumes of T-bonds, T-bills and T-notes China is buying. For example, see this and this. But that is a tough game to master, partly because China’s economic leaders aren’t dumb enough to telegraph their punch too early..

And remember, China isn’t the only player. For example, Abu Dhabi, Saudi Arabia, Kuwait and Qatar together hold an estimated $2.1 trillion in dollar reserves by themselves. If those 4 countries dumped the dollar, so would the rest of the world.

The private sector has already been moving away from the dollar. As the Globe and Mail noted in early 2008, :

A UBS Investment Research report says that while it would be wrong to write off the U.S. dollar as the global reserve currency, its roughly 90-year iron grip on that position is loosening. “The use of the U.S. dollar as an international reserve currency is in decline,” said UBS economist Paul Donovan.

“The market share of the dollar in international transactions is likely to decline over the coming months and years, but only persistent policy error – or considerable fiscal strain – is likely to cause the dollar to lose reserve currency status entirely.”

The UBS report maintains that the gradual slide of the U.S. dollar is being driven not by the world’s central banks, but by the private sector, as individual companies increasingly abandon the greenback as their international currency of choice.

“The private sector’s use of reserves is more important than official, central bank reserves – anything up to 20 times the significance, depending on interpretation,” Mr. Donovan said. “There is evidence that the move away from the dollar as a private-sector reserve currency has been accelerating since 2000.”

Because there is a premium to the value of whatever currency is the world’s reserve currency, the value of the dollar will decline in the years ahead.

In addition, Bernanke and the boys are running the printing presses 24/7, the banks have been given trillions to gamble with, the U.S. is running massive deficits with a massive debt overhang, the Fed is buying U.S. treasuries and the boys are engaging in various forms of quantitative easing, and the government is doing just about everything in the text book to lead to dollar devaluation.

Finally, investors are buying dollars at zero percent interest and – in a carry trade – using the dollars to invest abroad. This also devalues the dollar.

Arguments for a Short-Term Dollar Rally

So we should all be long other currencies (or gold) and short the dollar, right?

Maybe. But let’s look at the other side of the argument.

First, there are strong arguments for deflation for the short, and perhaps medium or even long-term. In deflation, every dollar buys more goods, and so the value of the dollar may rise in the short to medium-term.

Second, Marc Faber thinks the U.S. dollar is no longer overvalued at present levels, and that there might be a snapback rally for the dollar resulting from oversold levels.

Third, the inverse relationship between the dollar and stocks is well documented. And many commentators see a stock market decline ahead.

For example Roubini thinks stocks are overbought and will decline.Moreover, most Elliot Waver timers – such as Prechter, McHugh, Daneric and Mish – think we’re probably in for a huge “wave c down” stock market crash in the near future. Indeed, quite a few e-wave theorists are convinced that we’re about to experience the end of a “grand supercycle“, which means that stock values will crater.

Finally, very few predicted that the dollar would rally last year. But it did. And not only because people considered dollars or U.S. treasuries a safe haven. But also because of the huge margin calls, need to liquidate assets fast, and the urgent necessity of raising dollars to settle dollar-denominated contracts. In other words, another severe financial crisis could lead to another short-term dollar rally.

Bottom Line

The bottom line is that the dollar will get creamed in the long-run, but will probably rally whenever the next major stock market crash or next severe leg of the financial crisis occurs.

Whether you think that will happen quickly or sometime in the future is your call.

Note: There are obviously many other factors affecting the dollar as well. For example, if other countries cut their interest rates to zero and print as much money as the U.S., then the dollar will look a little better in the currency beauty show. If other countries raise interest rates and soak up excesses in the monetary supply, then the dollar will get somewhat uglier. The British pound sterling is hideous, and may be even worse than the dollar.

A default by another major economy may also make the U.S. look better.

The currencies of commodity-centric countries such as Brazil and Australia tend to rise when commodity prices rise, and fall when commodity prices decline.

There are other important factors as well.

I am not an investment advisor and this should not be taken as investment advice.

Source: Washingtons Blog