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Is a Dollar Comeback in the Works?

September 10, 2008 – by Richard Band

Earlier this week, the dollar traded at an 11-month high against the euro. Why?

For one, commodities are under extreme pressure. You’ve probably noticed by now that there’s a strong correlation between oil and currency strength—as crude oil prices pull back, the euro weakens; and as the euro weakens, the dollar gains strength (see also, “Profit From the Dollar’s Free Fall“).

The dollar has remained surprisingly resilient in the face of a slowing global economy, further big-bank write-downs and the slumping of pretty much every sector from commodities to retailers.

So—could the dollar actually recover?

The answer will have a vital bearing on whether investors allocate more (or less) of their money to investments at home or overseas. Global investing has become all the rage in recent years.

If, however, the dollar begins to appreciate in a meaningful way, currency losses will put a damper on many foreign investments.

We aren’t simply talking theory here. From 1995 to 2000, during the dollar’s last sustained uptrend, U.S. stocks outperformed the rest of the world (in dollar terms) by a wide margin. The same was true from 1990 to 1992. So what’s behind the dollar’s slide? Let’s find out.

Factor #1

The bursting of the Internet bubble and then the 9/11 attacks drove the U.S. economy into a recession.

To offset a slumping economy, the Federal Reserve slashed domestic interest rates well below those of our trading partners in Europe, Canada and Australia. Global investors dumped dollars in favor of higher-yielding currencies like the euro (see also, “How to Invest in Emerging Market Stocks“).

Factor #2

The Fed’s ultra-low rate policy in the early part of the decade also stimulated the now-bemoaned housing boom.

By allowing homeowners to extract equity at rock-bottom interest rates, the central bank triggered a consumption binge. Many of the goods consumers purchased were imported, driving the trade deficit up, and the dollar down. (see also, “Fannie-Freddie Bailout: What It Means to You“).

Factor #3

Finally, the government’s trillion-dollar tab for the Iraq and Afghanistan wars has forced the Treasury to issue large amounts of debt.

Since the end of 2002, the national debt has… soared by $3.2 trillion. Foreigners own up to 25% of the debt, but that percentage is slowly shrinking as the U.S. economy’s issues spread around the globe. Result: a lower dollar (see also, “Will the Election Save the Economy?“).

The View Going Forward

So where are these factors headed now?

Let’s take them in order:

Interest rates. Since last summer, the Fed has cut the short-term federal funds rate to 2% to combat the housing and credit crises—that’s much lower than the 4% average of our trading partners. However, this emergency rate can’t last much longer.

If not right after the November elections, by early 2009 I expect the Fed to bump up rates again. Meanwhile, central banks across the Atlantic, confronted with sharply slowing economies, may trim rates to ease growing recession pressures (see, “Three Tips to Survive a Recession“).

As our rates and foreign rates approach a common level, global investing will lose its appeal, and the dollar’s investment appeal will increase.

Trade deficit. American consumers are tightening their belts. As a result, the trade deficit for the first half of 2008 fell $7 billion below the same period in 2007, putting the United States on target to reduce the gap for a second year in a row.

If, as I expect, Americans remain penny-wise in 2009, the trade deficit could shrink further, boosting the buck even more.

Federal Budget Deficit. It’s ugly right now, no question about it. For full year 2009, the Office of Management and Budget is projecting an unparalleled $482 billion deficit. But that number could change for the better if (1) the economy improves, or (2) the Iraq war begins to wind down. In either event, Uncle Sam would issue less debt, making dollar-denominated paper more attractive to foreigners (see also, “Hot-Button Election Issues & Your Portfolio“).

Now, these fundamental factors really haven’t shifted much yet. We’ve only caught a mere glimpse of a possible stirring. In that sense, the recent dollar rally is speculative and premature at best. But that’s how all major market turns occur.

What to Do Now

In the meantime, you can plan your next steps.

I expect the dollar—after its recent bounce—to settle back a bit in terms of the euro. Should this be the case, I recommend holding on to whatever U.K. companies you may own because the British pound isn’t nearly so overvalued against the dollar (see also, “The Safest Way to Invest Overseas“).

If you’re interested in global investing, I’d also lock in a position in companies with growth potential in emerging markets, where many of the currencies are actually undervalued against the greenback.

We won’t really know for sure if the dollar’s trend change is legitimate until news filters in over the next few months and quarters. One thing, however, is for certain: If the end of the dollar’s weakness is approaching, a major market turnaround should be soon to follow.

So what are you waiting for? Get the loudest bang for your buck by joining me and my Profitable Investing subscribers for a ride on the greenback. I guarantee it’ll be worth your while. In the September issue, Richard Band reveals a pair of exchange-traded funds that will allow you to place leveraged bets on the greenback. Accept a risk-free trial and read the current issue immediately online. Plus, receive up to 7 FREE Reports. Click here now!

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