Top dollar no more?

Today, the pound strengthened for the 10th day in a row, climbing to 1.96 against the dollar, the highest level since September 1992 (when the UK currency was ejected from the ERM). When I started in the City in 1985, the exchange rate stood at 1.05$/£, and if it breaks 2 $/£ it’ll be at the strongest level since 1981. What’s going on?

 

In one word, “globalisation”. American consumers make UK consumers look tight with their money, with huge sums of money flowing from the pockets of American citizens into the pockets of businessmen in Asia. The trade deficit is enormous, standing at just under 6% of total US GDP. This outflow is the main reason why the dollar has weakened by so much.

What do Asian countries do with their money? They save a lot of it, and because many Asian financial markets aren’t particularly developed, a large proportion finds its way into the US equity and bond markets, pushing up stock prices, pushing down bond yields and supporting the dollar.

I believe the dollar will continue its decline over the long term. Global currency markets are constantly adjusting, reflecting changes in the flow of money to and from countries. Asian financial markets are developing rapidly, particularly in Shanghai, where the Chinese government is aiming to build a financial centre to rival New York and London. As Asian investors put more money into their own markets, and less into the US, the dollar will have to depreciate as demand for US dollar assets falls.

US dollar depreciation will prompt investors to diversify their currency risk away from the greenback. Indeed, this is already happening – oil is no longer denominated purely in dollars, but in euros too. US foreign policy is a major grievance for the Middle East, and Iran is threatening to trade oil solely in euros. Meanwhile, Russia and China, two countries accumulating large foreign currency reserves, are not exactly famous for their support of Uncle Sam, so it would be no surprise if they went down the same path.

The early stages of globalisation led to rising demand for US dollars. But the next stage of this process could well mean that it is only a matter of time until the US dollar is not the only de facto reserve currency for the world’s central banks.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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