Dollar rallies on flight to safety

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NEW YORK (CNNMoney.com) -- The dollar rose against rival currencies Monday as investors continue to view the U.S. currency as a safer alternative to more risky assets despite the nation's weak economy.

"We're still seeing a lot of nervousness in the market," said Kathy Lien, director of currency research at Global Forex Trading. "And that's why the dollar is still being bid against other currencies."

Even as the U.S. economy slips deeper into recession, the dollar has managed to maintain its reputation as a safe-haven. As a result, the U.S. currency often rallies when the economic outlook darkens and stock prices fall.

Stocks tumbled in afternoon trade, after an early rally fizzled, as concerns about the economy outweighed news of a $41 billion corporate merger.

The pound fell 2% against the dollar to $1.3816 after the U.K. government took a big stake in Lloyds Banking Group. The euro was down 0.15% versus the dollar to $1.2633.

British regulators struck a deal with Lloyds over the weekend to cap the bank's losses on risky assets at $370 billion. In exchange, the government could take as much as a 77% stake in the troubled bank.

That news highlighted concerns that the U.S. government could follow a similar path in dealing with troubled financial institutions in America, Lien said.

"A lot more uncertainty lies ahead for U.S. banking sector," she said. "U.S. fundamentals will only come back to forefront when the fear of a major U.S. bank failure evaporates."

Meanwhile, the dollar was up 0.5% versus the yen at ¥98.84, after Japan recorded its first trade deficit in 13 years.

The deficit came as demand for Japan's exports dried up amid the global economic slowdown and a stronger yen undermined profits earned overseas.

The yen's retreat, however, suggests that Japan's currency, which is also considered a safe-haven, is becoming more closely connected with the deterioration in nation's economy.

"The yen is decoupling from risk aversion," said Gareth Sylvester, senior currency strategist at currency brokerage HiFx in San Francisco.

However, even as the yen begins to reflect the downturn in Japan's economy, the dollar is expected to remain strong as investors shun risk, Sylvester said.

"The predominant theme remains risk aversion and dollar strength," Sylvester said. "That correlation is still strong."