Dollar's Descent Raises Questions
Despite worries about the sliding U.S. dollar and health-care reform, the Dow Industrials are within 40 points of their Aug. 27 closing high. Near-term trading will hinge on economic news, the health-care debate, and news regarding September-quarter results. As a hedge, we’re holding about 30% of equity portfolios in a short-term corporate bond fund.
Are commodity prices rising because of expectations of strong demand — or because of fears of continued devaluation of the U.S. dollar? While such questions are difficult to answer without the benefit of hindsight, even a partial answer could be helpful in handicapping the year-ahead investment outlook.
U.S. dollars represent a claim on U.S. assets. When the Federal Reserve creates money out of thin air, as it has done aggressively over the past year, the dollars held in your bank account are diluted. Printing money does not increase the value or quantity of U.S. assets, but it does increase the number of dollars with a claim on those assets.
Investors, especially foreign ones holding U.S. bonds, are rightly worried about this dilution. Cheng Siwei, a top member of the Communist hierarchy in China, told reporters that if the Fed keeps printing money to buy Treasury bonds, “it will lead to inflation, and after a year or two the dollar will fall hard.”
To hedge against this risk, investors are moving into assets denominated in foreign currencies or into physical assets like gold and oil. The dollar recently fell to its lowest level in nearly a year. The price of gold has jumped more than 10% since April.
While many investors are clearly worried about the U.S. dollar, other indicators paint a different picture. At 3.5%, yields on 10-year Treasury notes remain well below recent highs near 4.0%, suggesting investors do not anticipate a surge in U.S. inflation. More important, shares of transportation and other cyclical stocks have rebounded impressively, indicating investors anticipate real growth in the industrial economy.
If U.S. government authorities withdraw fiscal and monetary stimulus too soon, they risk a relapse into recession. If authorities continue to print money and run huge budget deficits, investors may lose confidence in the value of the dollar — and exit dollar-denominated assets en masse.
Against that backdrop, the debate regarding health-care reform deserves close attention. Legislation that slows growth in health-care costs could put the U.S. on a sounder financial footing, while legislation that creates another huge unfunded liability could be the last straw for worried foreign investors.