Island Investing: The Declining Dollar

Q. Why is the dollar declining, and what does that actually mean?

A. The value of the U.S. dollar affects everything from the stock market to gas prices to geopolitics. The dollar’s value is determined by its exchange rate, which compares our currency to that of other countries through open market trading. I will leave predictions about the value of the dollar to others, but it’s important to understand the effects of a falling dollar.

Several factors explain the dollar’s decline, but the most significant is that U.S. debt is approaching $12 trillion. Foreign investors who own our debt are concerned that our government will let the value of the dollar fall in order to decrease the value of our debt. This is also one reason foreign investors are diversifying their holdings away from dollars to other currencies and non-dollar denominated assets.

The news of a declining dollar is mixed. It’s good in that it makes our goods cheaper and more competitive overseas, which helps increase exports and boosts economic growth. A weak dollar is bad, though, because it eventually leads to inflation. Imports from other countries become more expensive here, so U.S. businesses raise prices on their customers.

One such import is oil, which illustrates one of the most noticeable effects of a falling dollar. Since oil is traded in dollars and the dollar has weakened, oil-producing countries raise the price of oil to maintain profit margins in their local currencies.

The recent decrease in the value of the dollar does not mean the United States is in decline, however. The dollar actually rose in value during the global recession earlier this year, primarily because the U.S. is still seen as a safe haven for investors. There are also only two other currencies capable of supporting the world’s cash reserves – the yen and the euro. Though the U.S. economy is in poor shape, it is significantly stronger than that of Europe or Japan, and our currency is still the most attractive.

So while we absolutely have to decrease our debt, the dollar is not going to collapse overnight, either.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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