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Dollar's Rebound May Push Oil Prices Lower—For Now

The weak US dollar, which has been a major factor in both oil and stock prices in recent months, is finally showing signs of rebounding.

But while a stronger dollar is likely to push record-high oil prices lower, many experts think both trends may not last long. The reason: global demand for oil remains strong, while continued weakness in the US economy will limit the dollar's gains.

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A strong dollar usually translates into weaker commodities prices, especially oil. A rare exception was last week when the dollar gained but oil surged on strong global demand and news of low fuel stocks.

Right now, the signs from the stock market, the economy and the Federal Reserve have analysts betting on a short rally for the US currency and a quick move lower for skyrocketing oil.

"We think we're in the midst of a commodities bubble, and one of the pins that could pop this bubble in fact is a strengthening dollar," says Hank Smith, chief investment officer at Haverford in Philadelphia. "So we could easily see a scenario play out out for the remainder of the year where the dollar strengthens, commodities come down, our economy picks up due to all of the stimulus that's been applied, and we end up the year in fairly good shape given everything that we've been through with the credit crisis."

But not everyone is as enthusiastic about the dollar's long-term strength, with most expecting a short-term dollar rally that will push the greenback's value up only mildly.

David Reilly, director of portfolio management at Rydex Investments in Rockville, Md., says his firm is "mildly bullish" on the dollar for the second quarter but sees fundamental factors such as the US trade and budget deficits and huge consumer debt tempering any gains. As such, the impact on oil could be minimal, though he does expect some pullback in price. Many analysts now are estimating oil falling to about $100 over the next few months.

"Long-term, the secular fundamental case for commodities is there. Short-term, the dollar rallying makes you want to step back a little bit from commodities," Reilly says. "The tricky part about it is it's almost impossible to say what is the fair market value for a barrel of oil like you can for a stock or a bond."

The dollar waffled Monday, posting early gains against the euro that it eventually surrendered while holding higher against the yen. Oil prices fell sharply earlier in the day, recovered somewhat then dipped again as the dollar moved higher against the yen and the stock market shot up.

Analysts are closely watching the banking situation in Europe. As the Fed has cut interest rates and weakened the US currency, the euro has overpowered the dollar because the European Central Bank and the Bank of England held rates level and supported their currency.

But that trend has shown signs of breaking as Europe begins to confront its own subprime mortgage problems and an ensuing credit crisis.

"The psychology around the dollar is shifting a little bit in the sense that in Europe we're starting to see some of the same real estate and mortgage problems that the US has been suffering from," says Larry Edelson, an analyst with Weiss Research's Money & Markets online newsletter. "There's a perception in the marketplace that the US is past its peak regarding the subprime crisis whereas Europe might not be."

But a soft US economy could continue to present problems for the dollar.

"It had really been beaten up so badly that it's not a big surprise that there was at the very least a short-term strengthening of the dollar," says Bruce Fenton, president of Atlantic Financial. "Longer-term I'm still not optimistic about the US economy and the dollar included."

"I think most of the world's savvy investors realize the dollar is likely to fall a lot more over the long term," Edelson adds. Creating inflation and drives up the value of assets against the debt used to pay for them is "how you ease the burden of massive debts that we have in this country."

But Brian Gendreau, investment strategist at ING Investment Management in New York, says one of the very reasons the dollar has rallied is that things aren't as bad as many thought.

"I think the market participants are smelling a rotation. If you look at what was causing the dollar to go down for a long time, it was the US economy was weakening when growth was holding up fairly well abroad," Gendreau says. "A lot of the news now is that the US economy is stronger than expected.

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