The Dollar Stages a Comeback the Hard Way

Of all the talk about a market bottom, one area that may well have found its turning point is the dollar.


After months of tumbling, the US currency is as close to a capitulation as any other sector, as it has posted significant gains against the euro and yen after hitting unprecedented lows. The dollar fell as the Federal Reserve launched an aggressive rate-cutting campaign that devalued the greenback while promoting liquidity and helping stave off at least a technical recession.

But with negative real interest rates--the comparison between the fed funds and inflation rates--the dollar still has managed to stabilize and is hinting at a comeback.

"I think the prospect for improvement in the value for the dollar is getting better everyday," said David Resler, chief economist at Nomura Securities International in New York.

In turn, analysts are pondering the dollar's future and its impact on other areas of the economy and the investment world. Some observations:

Recession Looms -- in Europe

The European Central Bank and its combative President Jean Claude Trichet have just about run out of tough talk against inflation and are going to have to confront the looming prospect of recessionary pressures similar to what have hit the US.

That means an increasing likelihood of interest rate cuts--similar to the Fed's methodology--that will weaken the euro but also increase liquidity and help keep the economy running.

In turn, the dollar is getting a boost from what many currency traders see as diminishing buying power for the euro ahead. That phenomenon is compounded by a still-strong belief that the Fed probably won't raise rates at least until 2009.

"The Fed hasn't raised rates, and in my judgment won't be raising them anytime soon because the US economy is still pretty fragile," Resler said. "The ECB's tightening bias has been a big factor in the dollar's weakness. I think that tightening bias is going to go by the wayside as the weakness in European economies has become more evident."

While the US economy is far from safe, it's probably already gone through some of the things--liquidity panic, banking instability, a collapse in the housing market--that some other economies are only beginning to feel.

And because the problems actually began in the US, that will only exacerbate the extent which they're felt across the globe.

"We have a highly integrated economy, with the US still being the largest. When the largest stumbles, the rest are likely to be caught in the fall," Resler said. "That's still the case. I think now we're starting to see some impact of the slowdown in the US being felt more broadly around the world."

Lower Oil Prices? Not Necessarily

Conventional wisdom had it that one of the reason's for the stunning surge in energy prices has been the weak dollar.

Oil trades in dollars, so those holding other currencies can buy contracts at a discount and use the rise in the commodity as a hedge against other market plays.

But economists have noticed that soon after oil passed $100 a barrel, the inverse connection with the dollar seemed to evaporate as prices surged regardless of the US currency's behavior. That could mean disappointment for those hoping a stronger dollar will mean savings at the pump.

The key to the breakdown in the connection could be growing faith that the dollar is coming back to life.

"One of the things we noticed is there were some real high-level people sent to the Middle east in March up until June," said Weiss Research currency analyst Jack Crooks, referring to several White House figures including Treasury Secretary Henry Paulson. "Our guess is maybe the oil producers in that area are just not reallocating back out of the dollar as fast as they were in the past."

At the same time, there continues to be strong sentiment that the commodity trade as a whole is unwinding, and the increase in value for the dollar will only exacerbate that.

"We haven't broken the relationship between the dollar and the commodities, but we have broken the speculative bubble," says Emily Sanders, CEO of Atlanta-based Sanders Financial Management. "The speculators are jumping for the exits at the moment so they don't get hit by a freight train. But that doesn't mean it can't turn on a dime."

Crooks said the commodities run is probably over, due in large part to demand destruction around the world.

"We're agnostic on commodities as an asset class," he said. "They're way above their cost. Usually commodities trend toward their production costs, so if we get a big decline in global demand this pullback could be a lot more severe than people think."

Some Will Benefit, Some Will Suffer

As the dollar grows and inflation probably tames, other areas of the economy and stock market invariably will pay the price.

Stocks, for instance, were cheered somewhat Friday on news that durable goods orders took an unexpected jump in June, a move largely attributed to a weak dollar that encouraged foreign investment. It's a pattern that would be challenged by a stronger greenback.

"Really, the dirty little secret is US exports are benefiting tremendously from a weak US dollar," Sanders said. "If it wasn't for the weak US dollar we would probably be in a technical recession. The weak dollar is making assets ... tremendously cheap in the eyes of countries with stronger currencies."

One of the big beneficiaries of a dollar uptick, even a minor one, could be simple market psychology, which has been a critical factor in a time when emotions have ruled trading to a higher degree than usual.

"The market right now is gripped by irrational pessimism," Michael Woolfolk, an analyst with Bank of New York Mellon, said on CNBC. "On a growth potential basis (the market is) supportive for the dollar now." See Video discussion on oil and currencies.

Some even are welcoming comments by Federal Reserve officials, who this week said higher interest rates need to be considered as a way to fight off inflation from rising food and energy prices.

"They're saying that they do not want the dollar to go lower, and it's not really in the vested interest of any country for the dollar to go lower," Crooks said. "The dollar is a raw material for the economy, and at this stage in the credit cycle there could be big advantages in the rising dollar in terms of putting confidence back in the system.

"It's psychology and confidence," he said. "A strong dollar provides that and it flows directly into equities, too."