Dollar jumps on talk of Fed rate rise

United States policy makers have added more than $12.8 trillion in credit market liquidity and stimulus to the financial system and the economy, prompting the dollar bears to yell, "the dollar must fall, big time."

So far, however, the dollar bears have been a very small choir, or at least singing at a very small club.
True, since January 1 the dollar has weakened about 20 percent versus the British pound, but it's basically unchanged versus the euro and the yen. On Monday the dollar strengthened about 1 cent versus the euro to $1.3875 and about one-quarter cent versus the pound to $1.5921; it was flat versus the yen at 98.38 yen.

The beleaguered buck

The dollar bears point to three factors that, they argue, long-term will force a drop in the dollar: 1) excess dollars in the global system, due to U.S. government spending and the U.S. Federal Reserve's banking system liquidity efforts, 2) the U.S. trade deficit and 3) the desire of major economies to diversify their hard currency holdings by selling dollars and buying the euro, yen, British pound, and Swiss franc. Some say the dollar may re-visit lows of $1.60 versus the euro later this year.

Further, emerging market nations China, Russia, and Brazil have all called for "dollar substitutes" in international market pricing systems -- either a switch to another hard currency (such as the euro), or a basket of currencies, as a way to protect countries and international investors against the reduced buying power that a depreciating dollar would bring. So far, the requests of the emerging market powers have not garnered much support.

Could the dollar stabilize?

Conversely, the dollar bulls argue the bearish argument is overestimating the negative factors weighing on the dollar and ignoring those working in the greenback's favor. Chief among these is the Fed, which they argue will increase the target lending rate by the end of the year as the U.S. economy shows additional signs of recovery.

"The market is thinking things are looking slightly better, and that's dollar-positive," Geoff Kendrick, a currency strategist in London at UBS AG, the world's second-largest currency trader, told Bloomberg News Monday.

Another factor likely to support the dollar, the bulls argue: the very nations whose currencies are strengthening versus the dollar. If those currencies, such as the euro, British pound, yen, Swiss franc, etc., become too strong, that will increase the price of their exports to the United States -- making those products and services less-competitive, all other factors being equal. The last thing these nations want is another commerce hurdle for their products and economies during the worst international trade conditions since World War II.

The dollar bulls also point to two other factors that are likely to bolster the buck: a decreasing U.S. trade deficit and a likely decline in oil prices. U.S. consumers have belt-tightened amid the recession, cutting their purchase of imported goods, which has the U.S. trade deficit dropping and trending lower. Meanwhile, oil's price is approaching bubble-ish levels and likely to fall, dollar bulls argue: historically, falling oil prices boost U.S. GDP, which is dollar-positive.

Dollar Analysis: Despite the flood of dollars into the system to counteract the financial crisis and the recession, investors need to keep in mind the large amount of dollars taken out of the system from stock, housing, and bond market declines and losses. Hence, although a Fed interest rate hike will support the dollar somewhat, the dollar's fate will likely hinge on the U.S. economy's recovery track: a recession that continues into 2010 will put pressure on the dollar; a recovery in place by Q4 will bolster the buck.

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