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August 24th 2008

Commentary: Dollar Rally- Fact or Fiction?

Over the last month, the Dollar has rallied tremendously, rising over 7% against its main adversary, the Euro. The price of gold, which serves as an inverse proxy for investor confidence in the USD, has fallen dramatically. As a result, many analysts have proclaimed that the Dollar has (permanently) bottomed out, and are busying themselves preparing projections for how high the Dollar will rise. But is the Dollar rally sustainable?

In the short-term, I would argue the answer is yes. The bubbles in the various sectors of commodity markets seem to have partially deflated, with oil and certain food staples well below the record highs they touched earlier in the year. As a result, inflation may soon begin to abate, and return to a comfortable level as early as 2009. More importantly, the US economy was among the first to be affected by the credit and real estate crises. Some analysts have argued that the worst developments have already come to pass. The crisis has since spread to the global economy, with other countries sharing in some of the burden. The result is that the US economic and monetary cycle is probably ahead of most of its peers. Accordingly, by the time the full impact of the crisis is felt by the rest of the world, the US should firmly be on the path to recovery. As other Central Banks move to ease their respective monetary policies, the Fed should be in a position to hike rates, providing further support for the Dollar.

As a result of this belief, US capital markets have received a sudden inflow of capital. This trend has been further buoyed by the notion that the US is the safest place to invest in times of crisis is gaining traction among investors. If the credit crisis continues to spread, this notion will no doubt be reinforced.

The long-term picture is of course more nuanced. The US will hardly emerge from the current crisis unscathed, and the ultimate cost of the credit crisis could exceed $1 Trillion. In addition, the US is unlikely to be shamed into changing its nasty habit of spending more than it saves. Accordingly, the twin deficits, those permanent thorns in the side of the Dollar, will probably persist. In addition, recent history suggests that investors are slow to absorb the lesson that There is No Such Thing as a Free Lunch. Despite the horrible collapse of the dot-com bubble, investors piled willy-nilly into the real estate market, with the result speaking for itself. Analysts are already speculating where the next bubble will occur; perhaps in alternative energy?

In conclusion, while the near-term prospects of the Dollar are surprisingly bright, the long-term prognosis is less so. There is no indication that the structural weaknesses in the US economy that led to the credit crisis and the multi-year decline in the USD that preceded it, will abate following its resolution. The future is inherently unpredictable, but I would expect the Dollar to continue declining once the global economy is back on track, perhaps in 2010.

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Posted by Adam Kritzer | in Commentary, US Dollar | No Comments »

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