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Why the buck stops here

The dollar has had a nice run, but a soft economy is likely to cut the rally short.

By Colin Barr, senior writer
August 13, 2008: 10:37 AM EDT

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NEW YORK (Fortune) -- The dollar has sprung off its deathbed, but a swift return to ruddy good health looks like a long shot.

After years of steady depreciation, the U.S. currency has rallied strongly this month. The surge in the dollar's purchasing power - a euro now fetches $1.50, down from $1.57 near the end of July and $1.60 in April - is good news for U.S. consumers, because a stronger currency makes imported goods cheaper and helps to hold down inflation.

And inflation, of course, can use some holding down: even after recent declines, the prices of commodities from crude oil to corn remain sharply above year-ago levels.

Unfortunately, the dollar may not be much help there in coming months, because its run may be coming to an end. Yes, it's true that European economies are struggling against a looming recession, which is bad for the euro. But the fact is that weak U.S. fundamentals - particularly in the housing and finance sectors, as well as the nation's need to borrow overseas to finance current spending - are likely to cap the dollar's gains.

"Nothing here is sunny," said CMC Markets currency strategist Ashraf Laidi. He likens the dollar's recent gains against the euro to a campaign between two unpopular politicians, one of whom "wins by default."

A sharp fall...

Of course, any victory seems appealing after the dollar's plunge over the past five years. When the euro was launched almost a decade ago, it traded at par with the dollar. The dollar then quickly appreciated, as money poured out of slower-growing European economies and into the red hot U.S. stock markets.

But those dynamics started reversing with the U.S. stock market crash of 2000 and the brief U.S. recession of 2001. They accelerated when Washington swung back to deficit spending after a brief run of surpluses. The housing boom kept the U.S. economy growing through the middle years of this decade, but investors started buying the euro and other currencies as Americans borrowed to finance their spending and the government borrowed to finance wars in Iraq and Afghanistan.

The flight from the dollar gathered more momentum as the U.S. economy slowed and the Fed slashed interest rates even as food-and-energy prices were spiking. The European Central Bank took the opposite tack, boosting its key rate by a quarter-point in July to 4.25%, a stance that stood to further boost the euro at the dollar's expense by widening interest-rate spreads.

Since then, though, data from across Europe and in the states of the former British Commonwealth have shown that the U.S. slowdown is spreading overseas. So the ECB and other foreign central banks now appear to be moving toward an easing policy.

...and a quick reversal

That shift goes a long way toward explaining the dollar's recent resurgence - though the speed of the reversal has surprised even analysts who were predicting a dollar rally.

As a result of the recent surge, "our bullish-looking [dollar] forecasts from not long ago are now on the near-term bearish side," analysts from Merrill Lynch wrote Wednesday. Merrill expects the dollar's gains to slow in the near term, as "the concerns about the funding of the U.S. deficit prevent some from embracing this [dollar rise] wholeheartedly." The firm does expect the dollar to appreciate to $1.40 to the euro in the first half of 2009.

But Laidi, of CMC Markets, says he doesn't expect to see the dollar continuing to gain ground against the euro or yen. Instead, he sees the euro trading at around $1.53 or $1.54 next year, and the yen at 101 or 102 to the dollar - against 110 now. Laidi says a sustained rise in the dollar would have to be accompanied by a peak in U.S. unemployment, a bottom in U.S. house prices and a general improvement in the U.S. financial sector.

Few expect to see those shifts any time soon. JPMorgan Chase (JPM, Fortune 500), one of the best-performing U.S. banks during the past year's credit crunch, warned Monday evening that market conditions have "substantially deteriorated" in the third quarter, leading to $1.5 billion of mortgage-related losses. UBS (UBS), which has been a much weaker player but nonetheless has global reach, likewise said it "does not expect any improvement in current adverse economic and financial market trends."

The U.S. has lost more than 400,000 jobs in the first seven months of the year, and economists say more layoffs are coming as retailers and automakers endure their latest retrenchment. Even Fed officials who have been sounding the alarm about inflation are saying they expect to see the economy struggle, a development that won't be supportive of higher values for the dollar.

"I expect that in the second half of this year we will broach zero growth," Richard Fisher, president of the Federal Reserve Bank of Dallas, told the Dallas Morning News in an interview published Tuesday. Fisher was the lone member of the Federal Open Market Committee to vote for a rate hike earlier this month, when the Fed held its fed funds rate target steady at 2%.

The one factor that could extend the dollar's gains, Laidi says, would be "a deepening of the weakness in the euro zone." Then, writes Northern Trust economist Asha Bangalore, the ECB could be forced into a swift reversal of last month's rate hike - an event that could boost the dollar as overseas central bankers are forced to follow, willingly or otherwise, in the Fed's footsteps.

"Euro-zone interest rates are probably on hold for the rest of this year," she wrote earlier this month, "unless the 'zone-wide slowdown starts to look like a collapse." To top of page

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