A Falling Dollar Could Spell Trouble Ahead
-- December 1, 2003

Stocks rallied again today, despite the fact that the U.S. dollar, the world's reserve currency, crumbled to an all-time low against the euro. Bond prices followed the dollar lower, pushing yields higher, while gold rose to a near eight-year high. The Bush administration seems pleased that the dollar is heading lower. It is helping to push a "little inflation" into the economy. But because the U.S. relies on others to fund its runaway spending, pushing the dollar lower can be dangerous. We could be getting closer to the danger zone than most now realize.

Over the past year, foreign central banks have increased their holding of U.S. securities by a whopping $150 billion, to $918 billion. The $150 billion increase now funds about 27% of the estimated $550 billion US current account deficit. That is double the amount funded by foreign holders just a year ago. And yet despite all this fresh money flowing to the dollar, it continues to fall lower and lower. Yikes!

Now think about this logically. You are a foreign central bank, holding billions and billions in U.S. assets denominated in dollars. Each day the dollar falls in value, you loose millions and millions in value on your U.S. holdings. At some point, as a foreign central bank, with a fiduciary duty to guard your own country's assets, you will have to "cry uncle." Enough is enough.

So instead of recycling all the dollars back into U.S. securities, imagine the damage to the dollar if those banks decide to buy euro- or Swiss franc- or Australian dollar- or yen-denominated bonds instead. It really is a frightening scenario -- the dollar would fall like a stone and U.S. bond prices would follow -- that would jack up interest rates. The stock market would crumble.

If the dollar continues its slide, that scenario may unfold for us all to see.

related article:
Stunning U.S. Data Fail To Boost Dollar; Euro Ebbs