Dollar Rally Gathers Momentum – for Now

Surprise, surprise; the U.S. dollar is making a comeback…

Since hitting a low earlier in July versus the euro at 1.60, the U.S. dollar has rallied a cumulative 6%. Over the same period, gold prices have also declined, down over 8.5% while commodities have crashed more than 15% off their all-time highs.

One of the most overvalued currencies in my eyes, the British pound, is now getting decked this week, down over 3.5% this month and off 7% from its high versus the dollar last year.

The dollar, in a secular bear market against all currencies since peaking in 2001, is now down just 2.8% this year as measured by the J.P. Morgan U.S. Dollar Index (see chart below).

Since mid-July, the U.S. Dollar Index has been forming a basing pattern and is clearly on an uptrend at a time when the American economy remains mired in a probable recession and overseas economies are deteriorating.

The dollar is now embarking on a bear market rally – and nothing more. There is no fundamental reason to buy the dollar beyond a quick trade that will eventually run out of gas; the Fed can’t raise interest rates in the midst of rising inflation and deflation in housing and bank credit.

Combined with rising unemployment and a tapped-out consumer following last spring’s government fiscal stimulus checks, the dollar’s gains will be short-lived. The buck is running hard since July because foreign economies are slowing and not because the U.S. economy is forming a bottom. Basically, credit problems and slowing economic growth are now spreading to overseas markets – evidently not de-coupled from Wall Street after all.

The market continues to discount a modest Fed tightening over the next six months while foreign economies are looking exhausted. Germany’s economy, the largest in Europe, posted a decline in Q2 GDP after leading all Euro-zone economies earlier in the year with robust economic growth. And in Japan, all signs continue to point to a renewed slowdown as Chinese and non-Chinese inter-Asian exports post marked declines compared to 12 months earlier.

Jack Crooks, Sovereign Society’s currency expert, correctly predicted a dollar rally a few months ago and remains bearish on the euro. I tend to agree.

Though I would not sell the dollar for euro or any other European currencies at this stage, I still like the Asian units, except the yen. I’ve downgraded the yen since July because the economy is heading southward again.

The dollar will continue to rally over the short-term and play off the weakness of foreign economies as they join the United States in a slowdown or recession. But at some point, I’m expecting the Fed to cut, not hike, interest rates again. This will probably occur before March 2009 as the economy struggles to find a bottom amid a deepening housing recession, rising unemployment and another financial time-bomb likely to drop courtesy of the banks or one of the Big Three auto companies defaulting on its debt.

Have a good weekend. See you on Monday.

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