WHY THE FALLING DOLLAR IS HARMFUL There are several reasons for foreign investors to stop buying Federal Government debt. One is merely the diversification motive. They already hold too many denominated assets. Second is the risk of default which grows along with our deficit. Third is the lack of returns or actual losses they incur as a result of the depreciation of the dollar.
The third effect is clearly illustrated in the chart below. It shows what what Americans earned (actually lost) with the 10-yr Treasury Bond (shown in red) versus what Europeans (shown in blue) lost.
The disparity in returns (a loss of about 3% for US investors and a lost of about 18% for European investors) results solely from the deteriorating value of the dollar. This differential developed over just 8 months, which is indicative of the rapid decline in the dollar. For US investors, investing overseas this process would work just the opposite way. For example, had a US investor invested in Euro denominated bonds over this same period, his return would have been in the area of 15%, again solely because of shifting currency rates.
HOW MIGHT I PROTECT MYSELF There are some that believe our dollar needs to decline another 50% from here and that the Fed is actually trying to engineer such a move over the next ten years. This policy has not been explicitly stated by the Fed or our Treasury (that assures us that a strong dollar is their policy). If you believe that the dollar will continue to decline relative to other currencies, one way to protect yourself is with non-dollar denominated investments. As an example, if the dollar were to decline another 50%, your investment return in foreign government bonds denominated in a strong currency would be equal to whatever interest payments you collected plus a 100% currency translation gain. (This assumes that the bond was held to maturity.)
This is not meant to be financial advice. It is merely an example of how one might try protect oneself if one believed the dollar were going to fall much further.
BIG RISK As a country, we have become a Blanche du Bois , “dependent upon the kindness of strangers.” We are unable to finance our deficits without their continued flow of funds into our Treasuries and other financial markets. The big risk is that they decide to stop sending us money. Why would they continue when their returns are as abysmal as the chart above shows? If that happens, we either have to cut back our government and standard of living dramatically, or we print money to cover the shortfall, leading to high inflation if not hyperinflation.