This has been a big year for the U.S. dollar (USD). The onset of the COVID-19 pandemic brought sweeping government stimulus and unprecedented policy moves from the U.S. Federal Reserve (the Fed). Subsequently, U.S. dollar devaluation became a primary theme throughout the second and third quarters of 2020.
As we move into late 2020, experienced investors and market newbies are asking one important question: Is it time to limit exposure to the USD? Although the situation remains fluid, there are reasons to believe that a sluggish greenback may be the new norm.
What Is U.S. Dollar Devaluation?
Pricing fiat currencies is a tricky business. Many factors determine a currency’s relative value—its worth in comparison to other monies. Central banking policy, economic performance, and outliers such as COVID-19 all influence a currency’s supply and demand. In some cases, these types of factors align to send a currency’s perceived value south.
So what is U.S. dollar devaluation? In simple terms, devaluation occurs when a currency’s purchasing power is reduced due to an expanding money supply. For the USD, this phenomenon may be the result of multiple external factors:
- Fed policy: Some monetary policies, such as interest rate cuts and extensive open market operations, promote the growth of the money supply. A byproduct of such policies may be decreasing the purchasing power of the USD and increasing inflation.
- Government stimulus: U.S. government stimulus packages are direct capital injections into the nation’s economy. These actions are designed to kick-start economic activity by making capital readily available. Examples of government stimulus are 2008’s Troubled Asset Relief Program (TARP) and 2020’s Coronavirus Aid, Relief, and Economic Security (CARES) Act.
- Inflation: Pricing inflation occurs when the cost of goods and services increases, thus decreasing the purchasing power of the USD. Rising inflation can be the result of Fed policy, government stimulus, or sectoral shortages of goods or services.
A recent example of dollar devaluation came in the late spring and summer of 2020 during the fledgling COVID-19 economic recovery. Following the signing of the $2 trillion CARES Act and adoption of the Fed’s program of “unlimited QE,” the USD entered a period of swift devaluation.
Both programs vastly expanded the supply of greenbacks, which prompted a downturn in valuations. As a result, the USD Index plunged from March 2020 highs above 102.75 to August lows just north of 92.00. Although inflation continued to lag behind expectations, the markets “priced in” the eventual impact of the rising money supply.
Managing Your Exposure to the USD
For those investors long the USD, March-August 2020 wasn’t pretty. Values slid nearly 10 percent as the markets priced in the monumental injection of capital into the U.S. economy.
How did savvy market participants limit exposure to U.S. dollar devaluation? Pragmatically, there are many ways to accomplish this goal. Here are a few of the most common methods:
- Buy/sell forex pairs: You can profit from devaluation by assuming long or short positions against the U.S. dollar. For instance, going long the EUR/USD and shorting the USD/CAD are both methods of betting against the greenback.
- Go long commodities: During periods of currency inflation, the prices of raw materials typically increase. Accordingly, you can benefit from a falling dollar by buying energies, metals, or agricultural futures.
- Buy stocks: Similar to commodities, American stocks normally appreciate during U.S. dollar devaluation. Although individual stock-picking can be a challenge, buying into the DJIA, the S&P 500, or the NASDAQ can combat a falling dollar.
By shorting the USD on the forex, buying commodities, or going long stocks, investors can minimize the negative impacts of dollar devaluation on their portfolios. Other strategies including buying/selling FX futures or acquiring physical gold bullion can also be effective, but the three methods listed above are better suited for retail traders.
Where Is the USD Heading?
Accurately projecting the future path of U.S. dollar devaluation is a complex undertaking. With 2021 rapidly approaching, here are three factors that will largely determine the value of the greenback:
- COVID-19: Future lockdowns stemming from a second wave of COVID-19 could bring heavy volatility to the USD. If spring 2020 was any indication, such an event would likely bring a short-term spike in the USD, followed by an intermediate-term downtrend.
- Fed QE: At the September Federal Open Market Committee (FOMC) meeting, Fed officials issued a cautious three-year outlook for the U.S. economy. Subsequently, most agreed that the COVID-19 recovery was to be long and arduous. The FOMC’s projections contributed to their call for interest rates to remain near 0 percent until late 2022.
- More stimulus: As of this writing, a second government stimulus package remains gridlocked in Congress. However, many expect additional legislation to pass, injecting additional trillions into the economy.
If you’re going to trade the USD, then it will be critical to stay on top of these issues. Fortunately, Daniels Trading offers an array of timely analytics, designed to keep you abreast of critical dollar-centric developments. Whether you’re interested in advice from professional Daniels Trading brokers or third-party resources, Daniels Trading has you covered.