The dollar is beautiful.  Beautiful, that is, compared to her competition for the world’s reserve currency. I meant to pen this several weeks ago.  In that time, the dollar has risen more than 5% against the Euro and other currencies.  I believe this trend will continue.  You see, currencies are both a beauty contest and a weighing contest.  The European Union has to bail out its banking systems.  The cost of monetizing Euro debt is going to run several trillion Euros.  That makes the Euro closer to a Lira than a Deutschmark.  Result: a weaker currency.  Further, currencies reflect a region’s economic growth prospects.  The growth prospects for the Euro economy are not rosy.  With its overvalued currency, the Euro’s growth prospects dim.  The Euro needs to fall in order to improve its competitiveness and future growth prospects.  When the Euro falls, the U.S. Dollar gains.

Swiss Franc pegged to Euro
In the last month, two events have reinforced the dollar’s strengthening.  First, the Swiss Franc had been acting as one of the last “iron-clad” hard currencies, but it lost its independent status.  It is now, for all extensive purposes, tied to the Euro.  This is probably a good thing, since a cup of coffee in Geneva is rumored to cost $11 these days.

With this event, investors lost the safe haven of the Swiss Franc.  Don’t get me wrong, it’s not that the Swiss Franc was ever a legitimate reserve currency.  It never had enough “volume,” to handle petrodollars.  (The Arabian Peninsula has more than half a trillion in dollar revenues per year.)  The Saudis were never exchanging most of those dollars for Francs.  But still, as long as the Swiss Franc has been rising these last few years against the dollar and the Euro, it created the impression among some investors that there was an alternative to the dollar.

ECB finally Softens
The next shoe to drop was at the beginning of September, when the European Central Bank (ECB) gave multiple signals that it will acquiesce to monetizing its banking problem.  Yes, that’s right, they will take a page out of the playbook of the Federal Reserve and use easy money to cover the bad loans and other issues of the weak European periphery economies (the PIGS- Portugal, Italy, Greece and Spain).  But easy money = an easy currency, which is one that is not hard and not strong.

Gold
Gold is also functioning as a currency, since it is one of the only storehouses of value, which can scarcely be “monetized” or inflated away.  But the Gold market is not large enough to handle the trade flows of imports and exports.

Conclusion
There is only one true reserve currency in the world, the U.S. Dollar.  Its demise has been greatly exaggerated.  To be a reserve currency, you must have political stability, large deep markets (large enough to absorb trillions of inflows and faith in the judicial system and the sanctity of contract and property rights.  No other currency fulfills these requirements today.  The Euro is a long-term candidate to be a reserve currency.  Theoretically, so are the Japanese Yen and, someday perhaps, the Chinese Yuan.  But each of those countries has very significant issues, which cause the owners of the trillions in petrodollars to find undying solace, for better and worse, in the US Dollar.  I don’t expect that to change in the next decade.

One last point.  If you live in the U.S., probably more than 90% of your future liabilities and other expenses are dollar denominated.
So whether the dollar rises or falls considerably you are unlikely to notice it most of the time.

Daniel A Barnes, CFA                                                      September 20, 2011
Lafayette, CA

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503.

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