Why You Can Still Bank on a Strong Dollar in 2010

The dollar's exuberance has made it hard for budget hawks -- particularly those running for office -- to argue the dollar's collapse is imminent unless urgent action is taken to reduce the federal budget deficit.The trillion-dollar U.S. budget deficits that we started running in 2009 should be a prescription for a weaker currency. But what's the dollar done to date? It's held its own this year against the world's major currencies and even risen against two biggies, the euro and Japan's yen. It's a market condition that's confounded the economic bears as well as fiscal conservatives.

The dollar's exuberance has made it hard for budget hawks -- particularly those running for office -- to argue the dollar's collapse is imminent unless urgent action is taken to reduce the federal budget deficit. Don't misunderstand, as Fed Chairman Ben Bernanke has repeatedly underscored, Congress needs to agree on a deficit reduction plan. But a dollar collapse is not on the horizon.

In fact, the dollar could rally in 2010 versus the world's other major currencies. Sound incredible? It's quite plausible. Here's why:

Part of the dollar's stability can be attributed to the euro's woes. The euro is the "alternate" global reserve currency. The eurozone's likely aid package to help deficit-plagued Greece achieve a sustainable, credible budget reduction plan will weigh on it.

Further, potential deficit problems in Portugal, Italy and Ireland will likely also linger in the minds of investors. To be sure, sentiment on the euro's creation remains net-positive. It has boosted commerce. But the eurozone's inability to legally control member-nations' fiscal policy remains one key euro weakness vis-à-vis the dollar and this has benefited the buck.

Attractive U.S. Investments

Another reason for the greenback's strength is Corporate America. U.S. corporations are lean, productive, cash-rich and well-positioned to meet the rising demand that will likely follow as the economic recovery progresses. As of Monday, 83% of S&P 500 companies that have reported earnings have beaten Wall Street's consensus estimate for the first quarter. (A consensus estimate beat rate of 60% is the long-term average.)

Revenue and earnings are rising. And U.S. inflation is still comparative low. It therefore goes without saying that dollar-denominated U.S. corporations will likely continue to be attractive investments for international investors. This in-flow of funds will continue to benefit the dollar.

Finally, all global reserve currencies are not alike. As noted, the euro has benefited Europe enormously by facilitating commerce and standardizing prices, among other advantages. It's also become an alternate reserve currency.

Nevertheless, so far it hasn't been able to supplant the dollar. Investors, and in particular institutional investors, keep a portion of their cash parked in U.S. Treasuries and other dollar-denominated investments in case the sky starts falling. What's more, many small investors and merchants in foreign countries also keep a small amount of dollars on hand as a safeguard against potential problems with their home country's currency.

The Dollar as a Sanctuary

Each dollar-as-sanctuary habit boosts the value of the dollar. It's sort of a premium that the dollar gets for having free, fair markets, a commitment to the rule of law and a right to petition the government for a redress of grievances.

What could change the dollar's outlook? Of course, as Fed Chairman Bernanke noted, Congress must begin to make the difficult decisions involving raising taxes and cutting spending to reduce, then eliminate, the budget deficit. If investors sense that Congress is "kicking the can down the road" again, they'll react by selling dollars.

Also, if the U.S. trade deficit, currently about $40 billion per month, starts to rise, that would transfer more wealth out of the U.S. and weaken the dollar. In addition, another large, sustained increase in oil prices to above $100 per barrel would also be dollar-negative by transferring wealth and slowing U.S. GDP growth.

But absent the latter, look for the dollar to stand up against the world's other, major currencies in 2010. A stronger-dollar scenario is quite possible, particularly if 2010 U.S. GDP growth is stronger than 3%.

Hence, if your investment strategy assumes a substantially weaker dollar, you may want to re-evaluate that strategy.
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