The emergence of the Euro and the recent decline in the US Dollar vis-à-vis key currencies does not seem to bode too well for the long term prospects of the Dollar. The Dollar has lost nearly 50% of its value against a trade weighted basket of currencies since 1985. Though the decline has been gradual, it appears to reflect a long term trend for the greenback. The trend also is also reflective of the Dollar gradually losing its status as the world’s reserve currency, a status it has held since 1945.
The Dollar has faced similar threats in the past from the Yen and the Deutsche Mark due to America’s poor economic performance in the 1970s and early 90s. However, these two currencies were unable to make much dent into the Dollar’s status as a world reserve currency due to the size of their economies being much smaller than that of the US. However, the emergence of the Euro zone as a trading block, represented by a common currency seems to have upset the equation for the US Dollar. The Euro is backed by an economy almost as big as that of the US, and is all set to grow in size as more members join the EU.
As the US Dollar loses its value, other nations may choose to offload some of their Dollar denominated forex reserves in favor of the Euro. It has been estimated that over 65% of the world’s wealth in savings and forex reserves is held in US Dollars. Not only this, but the US Dollar has traditionally been a ‘store of value’ and has offered US bonds as a safe investment haven to other central banks.
As the Dollar loses its shine, Central Banks would tend to swap some of their Dollar holdings in favor of the Euro. This would result in the further depreciation of the Dollar and an appreciation in the Euros’ value. A diminishing Dollar would also lead to other nations not finding it lucrative enough to invest in US treasuries. This would have a secondary impact on the US economy and the Dollar, related to the nation’s current account deficit. This deficit is financed by other nations investing their dollar reserves in US treasuries. If this virtuous cycle were to break, the US current account deficit may become unsustainable and could lead to a further fall in the US Dollar.
Statistics seem to support the fact that the Euro is gradually emerging as an alternative reserve currency leading to a gentle fall in the Dollar’s value. It has been reported that estimated Dollar holdings of the world’s central banks has fallen from 73% to 64%, while that of the Euro have gone up from 18% to 26%.
Well, so what should a currency trader make of this long term story about the Dollar and the Euro? While, such a shift seems inevitable, the transition is likely to be gradual and one could expect the Euro to surpass the Dollar over a period of 10 years. So for now folks, its best to concentrate on a short term assessment of your forex strategies and make hay while the sun shines, while bearing in mind that the world is likely to crown a new Currency King in the future!!