As the global economy strengthens, the dollar weakens

If the euro's rally against the dollar is in its last stage, it's an awfully long stage.

The dollar's recent decline versus the world's other major currencies may strike the typical investor as somewhat of a paradox: the dollar strengthening in a U.S. recession, but weakening amid signs of a U.S. economic recovery. But this is not really a surprise, at least to the trained, professional currency trader.

Why would the dollar weaken just when U.S. investments started to become more attractive? Basic law of supply and demand. Simultaneously, it looks like the global economy is recovering, making international investments -- particularly potentially high-returning investments in Asia and Latin America -- more attractive, as well, luring capital out of the dollar and weakening the buck.

Rise in risk appetite hurts the dollar

The increase in risk appetite continued to hurt the dollar Tuesday, as the greenback weakened another one cent versus the euro and Swiss franc to $1.4236 and $1.0838, respectively. The dollar also fell about 1 yen to 95.60 versus Japan's yen and was virtually unchanged versus the British pound at $1.6447.

Further, if signs of Asia's economic recovery become more obvious, led by the rebound in China's manufacturing sector, the dollar will come under even more pressure, many economists agree.

Export-oriented economies in Asia sustained large losses in revenue when consumer demand in the United States collapsed, prompting many to bolster domestic demand in the home nation. Those emerging market economies are now viewed as being more capable of self-sustaining, stronger internal growth -- growth that's likely to attract institutional investor capital.

Another factor weighing on the dollar: the fear of rising U.S. inflation. It's not so much that economic conditions are dramatically better in euro-zone Europe or the United Kingdom -- they aren't. It's more that institutional investors fear that the U.S.'s large back-to-back-to-back $1 trillion-plus budget deficits will lead to 1) increased taxes or 2) further money supply expansion, fanning the flames of inflation in the U.S. Either action would deteriorate the value of U.S. investments, and that sentiment has also weighed on the dollar.

Nevertheless, there are those who believe the euro's rally against the dollar may be a Pyrrhic victory.

UBS AG Chief Currency Strategist Mansoor Mohi-uddin, Zurich head of the world's second-largest foreign exchange trader, told clients Monday he expects the dollar to strengthen to $1.30 versus the euro in three months.

"We remain positive on the U.S. dollar and think that the greenback is likely in its final stage of weakness," Mohi-uddin said, Bloomberg News reported Tuesday. "Equity and bond flows have the potential to surprise and could lend support to the dollar."

Currency Analysis: A dollar rally amid a record U.S budget deficit, Fed efforts to re-liquefy credit markets, and rising oil prices? For a dollar to strengthen in that environment, that would imply a strong U.S. economic recovery in the quarters ahead. So far, almost no economists are predicting that, which argues that talk of a dollar rally must be viewed critically and with caution.

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