Dollar's biggest risks: Europe and the Fed

October 23, 2011: 8:11 AM ET
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NEW YORK (CNNMoney) -- CNNMoney guest columnist Scott Boyd is a currency analyst with Toronto-based foreign exchange trading firm OANDA.

It's been another challenging year for the American economy.

Unemployment has been stuck above 9% for months, consumer spending has been stuck in a rut, and overall growth has slowed. Yet, the dollar has still managed to make substantial gains against other major currencies.

For several weeks, 60% of those trading the euro against the dollar have been buying the dollar. And for those trading the U.S. dollar against the yen, more than 80% have favored the dollar over the yen.

Before you break out the champagne. There are risks looming on the horizon that could derail that strength.

For one, the U.S. economy has slowed to the point of standstill with a return to recession not yet out of the question.

After a 0.7% increase in consumer spending for July, consumer spending only managed a disappointing 0.2% increase in August.

Early indications suggest September will likely follow the same trend with the most recent consumer sentiment index falling to a three-year low.

And looking abroad, Europe's sovereign debt crisis has also been a boon for the dollar. It's clear, upon closer examination, that the U.S. dollar's rebound in the third quarter had as much to do with growing pessimism in other countries, as it did with anything else.

Given these concerns, the fact that investors have been loading up on U.S.-denominated securities may seem counterintuitive.

Keep in mind, however, that, as is often the case during times of uncertainty, the dollar has once again assumed the mantle of "safe haven" status.

Regardless of the problems facing America, investors continue to feel that the U.S. is better positioned to weather an impending economic storm than most other economies.

This flight to safety helped contribute to the dollar gaining nearly 6% on the euro in the three months ending in September. Of course, past performance is no guarantee of future returns, and there are two potential events that could mean the dollar's run is coming to an end.

Firstly, the question of the Greek debt crisis and the impact that could have on the euro.

If the arrangement sponsored by the European "troika" (European Union, European Central Bank, and the International Monetary Fund) manages to prevent a Greek default and ultimately keeps the eurozone intact, it will likely reduce demand for the dollar.

Is the Fed out of bullets? Maybe

The other potential dollar-devaluing event is the likelihood of further quantitative easing by the U.S. Federal Reserve.

At the Fed's two-day retreat at Jackson Hole, Wyo., in late September, the Fed revised its outlook for U.S. growth downwards based on the latest information. This updated assessment could force the Fed to implement a third round of quantitative easing.

The Fed's first two efforts at quantitative easing (increasing the money supply to stimulate economic activity) have proven controversial. The results have been mixed at best and the proliferation of "cheap" money not only adds to the overall money supply thereby devaluing the currency, it also increases fears of inflation.

Rather than committing to an official quantitative easing program at this time, the Fed has announced "Operation Twist" in the interim. That's the name given to the Fed's plan to sell short-term securities in its inventory with the proceeds to be used to purchase longer-term bonds.

Is Operation Twist already a failure?

The Fed expects this action will lead to lower yields on long bonds and should discourage investors from simply buying and holding bonds. This is expected to free up more cash which will find its way back into the financial system.

For the Fed, this helps meet the goal of increasing liquidity without physically adding to the money supply thus avoiding the devaluing effect that comes with quantitative easing.

Whether Operation Twist will be sufficient enough to negate the need for the Fed to take further action, remains to be seen.

-- Scott Boyd also contributes to OANDA's MarketPulse FX blog. To top of page

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