The Panic About the Dollar Revisited
This has been an interesting few months. Quantitative easing officially ended. Oil prices dropped substantially and pose interesting geo-political implications yet to be seen. And through all of this, markets continue doing their thing: absorbing new information and attempting to create a fair price for an asset.
One of our main principles that differentiates our type of investing with most others is that there is no crystal ball, and you actually don’t need one. When we act on speculation, we will often find ourselves on the wrong side of the trade. For instance, it wasn’t all that long ago most everyone was concerned about interest rates going up with the end of quantitative easing. Yet quantitative easing is officially over, and interest rates haven’t budged. What’s so bad about higher interest rates and more income from bonds anyways? It wasn’t all that long-ago people were concerned about peak oil and sky-high prices. Oil prices are now at new lows even with all the unrest in the Middle East, undermining Russia’s fiscal position.
It also wasn’t all that long ago that people were concerned about the US Dollar, its eventual decline and America’s deteriorating position in the world order. It reminds me of the December 1st – 7th 2007 cover story of The Economist.
The article highlights the downward pressures on the dollar: the “cyclical divergence between America’s economy and the rest of the world,” the Federal Reserve lowering interest rates, bad mortgages and credit default swaps being denominated in dollars, emerging economies being less inclined to issue their debt in dollars, Gulf states facing rising inflation and pressure to trade oil in something other than the dollar, and the emergence of the Euro as an alternate reserve currency. For all of these reasons, the article suggests we have the ingredients of a nasty crash. According to the author, the solution was international co-operation between China, the Gulf States and the rest of the world in “an orderly decline of the dollar’s dominance.” International co-operation. Sounds like a stretch.
Many investors who acted upon these thoughts overemphasized international and emerging market stocks and bonds and gold in their portfolios for less than spectacular results. But let’s take a look at what happened next.
The dollar continued to decline for the next few months or so since the article was published. The yield on dollar assets declined with interest rates and investors could make more money on the bonds of other countries. But then the financial crisis happened. Safety trumped higher yields. It quickly became clear that lowering interest rates was a net benefit for the economy and the dollar soared about 22% against other currencies in just a few months. So far this year, the dollar is at it again.
Now what happened to that “cyclical divergence” and the U.S. losing its top spot in the world order? The U.S. is still the world’s strongest economy. What happened to lower interest rates putting downward pressure on the dollar? Quantitative easing has ended in the U.S. and is just now being considered in much of the world years after the financial crisis. And what happened to the Euro being a safe alternate currency? Concerns about a breakup of the European Union and secession movements have dampened those sentiments.
All of this is not to say that we expect the current trend to continue and should only be invested in the U.S. International exposure is important in the long run. It’s just to say that when it comes to speculating about the future, we’ll take the 5th. This will allow us to focus on what we can control: diversification, risk exposure, investor discipline, contribution and withdrawal rates, etc. (i.e. the stuff that matters).