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Is Dollar Doom Overhyped?

By: Richard Feldman

By: Richard Feldman, MBA, CFP®, AIF®

There have been a lot of discussions over the last several years regarding the dollar’s place as the number-one reserve currency in the world and speculation about its eventual fall from grace.

After all, the dollar has depreciated by 36% from the end of 2001 to the end of 2008 against the euro, making an investment in that currency 56% more valuable once it was converted back to dollars even before considering any appreciation of the underlying investment.1

The financial crisis brought about many shocks to the financial system. One of the trades prevalent was a flight to quality and liquidity, meaning that the dollar appreciated strongly against other currencies around the world. Below is a chart of the EUR/USD that represents the strength of the euro relative to the dollar.

As you will see in the chart, the euro depreciated from approximately 1.60 in early April 2008 down to 1.25 in November of 2008 and again in March of 2009. This approximates a 20% increase in the dollar against the euro, coinciding with the financial panic of this period.

Once the flight to quality subsided and institutions and individuals started adding risk to their portfolios, the dollar once again resumed depreciating against the euro and most other currencies around the world given the following factors:

  • The U.S. is enduring stagnated economic growth and embarking on massive fiscal and monetary policy stimulus.
  • Tax revenues are falling due to the economic collapse and high unemployment.
  • The U.S. is running very large budget and trade deficits.

Dollar Reversal
The dollar has found new strength recently with the fiscal problems that are happening in the smaller euro zone countries like Greece, Spain, Portugal, and Iceland. The chart above shows how the euro has depreciated against the dollar by approximately 11% over the past three months. There has been some talk within the financial media of the euro trading back to parity versus the dollar in the next year or so, something that seemed almost unthinkable based on what the financial press was saying about the dollar less than a year ago. The Economist ran an article titled, “The Diminishing Dollar” in October 2009, suggesting that the world would grow tired of the United States’ gaping deficits and that interest rates would soar and the dollar would slump.

Summary
There has been some speculation that the dollar is not so much appreciating but that the euro is in effect depreciating due to the current issues that are being felt within the euro zone. Diversifying your currency exposure on a worldwide basis makes sense from a portfolio construction standpoint. Most inflows last year went into international and emerging market equity mutual funds due to their out performance on a worldwide basis as a result of the depreciating dollar, while domestic U.S.-based equity mutual funds observed net outflows. I would imagine that the recent strength in the U.S. dollar will start to improve the flow of funds into domestic mutual funds, since most investors tend to chase the most recent trends in the marketplace.

1: Ameriprise Financial – Currency Risks & International Investing