The US dollar is the world’s de facto reserve currency, because there’s no law, requirement or global agreement conferring dominant status on the greenback. It’s a function of the dollar’s wide circulation, extreme liquidity and general stability. At almost any spot in the world, you can find someone willing to trade goods or services for the currency.

The dollar has held that reserve currency status since the end of World War II, despite a host of wars, recessions, crises, and political battles. Back in the early 1970s, the very nature of the dollar changed when President Nixon ended the last vestiges of the gold standard. All of these events caused volatility in the currency and raised some eyebrows, but never seriously endangered the dollar’s reserve currency status.

But this time is different.

The US Dollar Index compares the performance of the dollar against a basket of world currencies. As you can see from the graph below, the dollar had been showing strong appreciation throughout the late 1990s and, if earlier data were shown, you’d see the same trend going back for nearly two decades. That marked a period of almost unprecedented prosperity for the US with inflation largely in check, essentially full employment and rising incomes.



In 2002, that trend reversed itself, though, as cracks began emerging in the US economy and the Federal Reserve crash-dived interest rates, the deficit began to rise and the US embarked upon two unfunded military conflicts abroad.

The new downward trend didn’t show a meaningful reversal until the US mortgage debacle sparked off a global financial crisis, causing a sudden rush into the safe haven of US dollars.

While the root cause of the crisis may have been found on US shores, the rest of the world knew we would do what it took to get our economy humming again. As a result, the dollar enjoyed a period of resurgence until 2010.

Then the fleas on the dollar once again began to itch.

A number of emerging markets—particularly larger ones such as China, Russia and Brazil—have been lobbying for the creation of another global reserve currency. Many of them have also begun using their own currencies in trade, entering currency swap arrangements to limit currency volatility and make bilateral trade easier.

As a result, the dollar as a percentage of the total world money supply is shrinking, falling from nearly 90 percent in the 1950s to about 15 percent today.

At the same time, other global economies are showing signs of recovery, particularly Europe. While I won’t even try to count the fleas on the euro, the region’s nascent recovery and America’s own problems are spurring the currency higher.

Right now, though, the greatest headwind against the dollar is the US government.

Winston Churchill famously said, “You can always count on Americans to do the right thing—after they’ve tried everything else.” But over the past two years, the flaws in that belief are coming to light.

In August 2011, Standard & Poor’s downgraded the US credit rating from AAA to AA+ for the first time in history as Congress battled over raising the country’s debt ceiling. Those negotiations went well past the eleventh hour, making the markets extremely nervous and highlighting previously unthought-of political risks.

Just this month, the country endured a shutdown of the federal government that ran over two weeks, as Congress and the Obama administration battled over the government’s budget. Despite the shutdown and drama, no budget deal was reached. Rather, a continuing resolution was passed that essentially maintains the status quo until February, when the country will likely relive this drama all over again.

When a country’s budget process becomes more akin to a hostage situation, the currency is bound to suffer.

In fact, the dollar is currently trading at an eight-month low thanks to the government imbroglio, while the implied volatility measure of the euro, yen and a number of other global currencies are at recent lows. Needless to say, the dollar has been much more volatile over the past three months.

It’s a sad state of affairs when the US government has become public enemy number one with regards to currency stability, with no end to the squabbling in sight. It also muddies the inflation outlook.

The US has always been a major importer, buying $228.6 billion worth of goods and services in the month of July alone. Considering the nation’s reliance on imports, the fact that the dollar is the world’s reserve currency is precisely why inflation hasn’t been a major problem in the US.

But as confidence in the US dollar slides, it takes more dollars to buy the same volume of goods and services from abroad, increasing nominal costs. That, in turn, helps to drive up inflation, particularly in the case of energy as the US continues to import about 15 percent of the oil it consumes.

Thankfully, though, that weak dollar trend is helping many of our portfolio holdings. The greatest beneficiary thus far has been iShares MSCI Australia Index Fund (NYSE: EWA).

While the fund’s holdings in the mining and energy sectors have been benefiting from a resurgent Chinese economy—gross domestic product growth picked up to 7.8 percent year-over-year in the third quarter—the biggest performance driver has been the diving dollar. The Australian dollar is currently trading at its highest level since June relative to the US dollar, thanks to US political turmoil as well as the better-than-expected Chinese economic data.

Pall Corp (NYSE: PLL) will also benefit from the weaker US dollar, though that won’t be as apparent for at least a couple of quarters.

While the company definitely caught a currency tailwind in its fiscal first quarter, with more than two-thirds of revenue coming from outside the US, a weakening dollar works in Pall’s favor. That’s particularly true as revenue in its life sciences division is growing by better than 6 percent even excluding forex changes, more than offsetting the slight weakness in its industrial division.

Continue buying iShares MSCI Australia Index Fund and Pall Corp up to 30 and 80, respectively.

Overall, only two holdings probably won’t realize a meaningful gain from a depreciating dollar: Wells Fargo & Co (NYSE: WFC) and Norfolk Southern Corp (NYSE: NSC).

In the most recent quarter, Wells Fargo posted its 16th consecutive quarter of profit growth, hitting $5.6 billion, or $0.99 in earnings per share (EPS), in the third quarter. That was despite the fact that revenue declined slightly from $21.2 billion in the same period last year to $20.5 billion in the quarter. Foreign exchange had an impact of just $18 million in the quarter, a mere drop in the bucket.

Norfolk Southern doesn’t even report a foreign exchange impact on earnings and revenue, though it does realize some margin benefit from a weak US dollar that makes American coal and other bulk commodities more attractive.

Continue buying Wells Fargo & Co up to 45 and Norfolk Southern up to 83.

A declining dollar will certainly pose a challenge from an inflation perspective. However, our portfolio is positioned to benefit from long-term weakness in the US dollar, given our diversified currency exposure through our exchange-traded funds (which don’t hedge their currency exposures), and the geographically diversified revenues of most of our portfolio holdings.