Key Takeaways
- Foreign countries are increasingly looking to diversify foreign exchange holdings away from the U.S. dollar.
- Years of easy monetary policy and growth in government debt have weakened the dollar and produced inflation.
- We believe the dollar has few potential rivals and it should remain the mainstay of U.S. investors’ portfolios.
The U.S. dollar has been the world’s leading reserve currency held by other countries to stabilize their own currencies and facilitate international trade since World War II. The size of the U.S. economy, its military strength, its large and liquid capital markets, and its relatively predictable political environment all contribute to the dollar’s importance on a global scale. These attributes benefit foreign countries that hold U.S. dollar-denominated assets, and the appetite for its currency provides advantages for the United States as well.
Over the last decade other countries have gradually diversified away from the dollar for a variety of reasons with the Chinese renminbi, Japanese yen, and Euro all growing in importance. China in particular has benefited from its large and growing role in global trade. The movement to replace dollar holdings has intensified in recent months as major geopolitical rivals including China and Russia see an opportunity to reduce the influence of the United States. Both countries would like to see an increasing role of the renminbi over time, providing a counterbalance to the dollar and U.S. economic power.
The Dollar’s Declining Dominance
Economic concerns have also contributed to a desire to hold other currencies. Thanks to longstanding imbalances between tax revenues and spending, government debt now totals more than 120% of GDP, and periodic partisan debates over the debt ceiling have forced foreign investors to question the safety of U.S. government debt.
The U.S. is Spending Beyond its Means
Aggressive monetary policy in the years since the 2008-2009 financial crisis has exacerbated these worries. The Federal Reserve’s balance sheet exploded in size during the global financial crisis in 2008-2009 and again as it responded to the COVID-19 pandemic in 2020, and an extended period of low interest rates over the past decade likely contributed to inflation as well.
The Fed’s Balance Sheet Continues to Grow
The Dollar Remains a Safe Haven
Even with the dollar’s problems, the U.S. remains a safe haven relative to other options. The renminbi is growing in importance for global trade along with the Chinese economy. However, capital controls make it difficult to move money in and out of the country, and the government also tightly manages exchange rates. Differing fiscal policies across Eurozone governments are a major weakness of the euro—southern European countries like Greece and Italy are profligate spenders while Germany maintains a much more conservative stance. Moving down the line, the economies of countries like Japan and the UK are far smaller and share some of the same problems as the dollar. Gold has been falling in importance for almost 100 years due to the increased ease of currency conversion, price volatility, cost of storage, and an unwillingness to outsource monetary policy to gold miners. Finally, the Federal Reserve is tightening to fight inflation, which should boost the attractiveness of dollar-denominated assets.
There are also practical reasons to hold domestic assets. The vast majority of U.S. investors have expenses and liabilities denominated in U.S. dollars. Unless the dollar collapses relative to other currencies, an unlikely scenario for the reasons outlined above, stocks, bonds, and other investments that produce income in U.S. currency are best suited to fund these obligations.
International Stocks and Bonds Provide Currency Diversification
That said, currency diversification plays an important role in the portfolios of individual investors as well as global central banks. Foreign stocks and bonds provide a hedge against a falling dollar, as companies outside the U.S. produce income in other currencies and are priced in foreign currencies. International stocks tend to do well as the dollar weakens, and after a decade of dollar strength, foreign stocks finally began to outperform earlier this year.
Exposure to foreign currencies can play an important role in portfolios, especially in periods of dollar weakness. We encourage you to talk with your financial advisor to consider the best options for your unique situation. If you are looking to make a change and start a new relationship or would like a second opinion, the team at Fragasso would be happy to work with you. contact us