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Who sets the value of money?

The US Dollar is considered one of the strongest currencies in the world, but that doesn’t mean it hasn’t lost considerable value over the last decades.

In 1808, one Dollar bought you 2 pounds of ground coffee beans whereas today it barely pays for a lukewarm espresso from a gas station vending machine. In the ‘40s you were able to buy 4 cinema tickets to see the latest adventure playing out on the silver screen, but today that same single Dollar pays for a third of a water bottle sold at the theatre.

What causes the value of USD to change? And what can you do to, at least partially, escape it?

3 ways to measure the value of the US Dollar

Just like the value of goods and services, the value of money is determined by the demand for it. Generally speaking there are three ways to measure the value of the US Dollar.

The first is to look at foreign exchange rates, and measure how much the dollar can get you in currencies from other countries. As the world’s leading reserve currency, USD is represented in each of the world’s 7 largest FX trading pairs which are EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, NZD/USD. Together, these 7 major currency pairs make up about 80% of total forex trading activity on a daily basis.

The second way to measure the value of the US Dollar is by looking at the value of Treasury Notes. Treasury bills, notes, and bonds are fixed-income investments issued by the US Department of the Treasury. When the demand for Treasury notes is high, the value of USD rises along with it. Demand for Treasury Notes is driven by a large number of factors, with the Fed Funds Rate as one of the most important ones as investors want a higher rate for a longer-term Treasury Note.

The third method is to look at the USD denominated foreign exchange reserves held by foreign governments. The more US Dollar foreign governments hold in reserves, the lower the global supply which makes it more valuable. In one of the biggest hypothetical black swan events, if the world’s governments currently holding large amounts of USD would all sell their greenbacks at the same time, the US Dollar would collapse and the US economy with it.

Reasons why the value of money changes

Even though traders and institutions have bought substantial amounts of USD as a safe haven causing the US Dollar to increase in value during the last decade, the major trend of USD value is one of decline. That affects every day consumers when they pay for inelastic goods such as groceries – no matter what happens to the value of the currency you’re holding, you still need to eat.

That change in value is true for most currencies and has everything to do with inflation. The inflation rate is the percentage increase or decrease in prices during a specified period, usually a month or year. The percentage tells you how quickly prices increased or decreased during the period.

Inflation levels of 1% to 2% per year are generally considered acceptable, while inflation rates greater than 3% represents a dangerous zone that could cause the currency to become devalued. Anything above 50% is called hyperinflation and signifies the economy is in turmoil. Case in point, Venezuela clocked an average inflation rate of about 438% in 2017 when its economy collapsed.

Deflation, which is what happens when the value of money increases, may sound better at first but has its own way of wrecking an economy. Yes, you can buy more tomorrow with the Dollar you have today, but the fear of rapidly plunging prices tends to make people hold on to their money slowing down economic activity.

Protecting the value of the money you have

Escaping inflation and preserving wealth, is the goal of parking assets in safe havens. Traditionally, gold was considered a safe haven by many but over the last few years the precious metal has fallen out of favour both with institutional players and retail investors alike.

Bitcoin on the other hand has seen a steady surge in investor interest. Heavy weight professional investors and institutions have starting put more of their cash reserves in Bitcoin in 2020 not to speculate on the asset’s price action, but simply to counter the effects of holding large reserves in cash that lose value over time.

While it’s true that Bitcoin is considered an extremely volatile asset, this new wave of institutional money flowing into the market has so far shown to stabilize BTC compared to pre-2020 markets. When names like Paul Tudor Jones, Bill Miller, Square, PayPal, and MassMutual buy into Bitcoin, it’s not to buy the dip and sell the froth to make a few quick gains. It’s to activate otherwise dormant wealth that does nothing but depreciate in value as inflation slowly eats away the purchasing power of the Dollar.

In fact, the decline of US Dollar value during the COVID-19 pandemic has been a contributing factor to the boiling hot equity markets that seem to go nowhere but up. Fund managers, institutions, and retail investors are all preserving the value of the money they have by putting their cash to work – investing in a variety of different asset classes to minimize risk. All you need to do, to preserve your wealth, is secure yields that are higher than the inflation rate.

Bitcoin, as an asset seemingly uncorrelated to equity markets or at least alternatively correlated, with a 290% increase during 2020, certainly belongs in a well-diversified portfolio designed to preserve wealth.

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