The Dollar's Comeback: What Investors Should Know

The greenback's sudden strength against key currencies may reflect expectations of overseas economic weakness, not confidence in U.S. growth
by David Bogoslaw
The slumping U.S. dollar has resulted in the best of times for foreign tourists in the U.S.—and for U.S. outfits that export their goods. Keeping up the Dickensian conceit, it's also meant the worst of times for U.S. consumers' purchasing power.
The dollar's sustained deterioration over the past six years, and its plunge in the last year, have been all that and more. And that's made the greenback's recent comeback vs. other major currencies all the more remarkable. Some view the dollar's big bounce over the past week as a sign of growing confidence in U.S. growth prospects, but it may turn out to be nothing more than a tale of two (or more) diverging monetary policies.
On Aug. 5, the Federal Reserve's policy committee left the federal funds rate alone at 2.0%. Two days later, the European Central Bank kept its key interest rate steady at 4.25%. The Fed said tight credit, ongoing housing market contraction, and rich energy prices would probably continue to hamper economic growth over the next few quarters, and it said it expects inflation to moderate over the next 18 months. The ECB seemed more willing to recognize downside risk to economic growth in the euro zone, possibly even anticipating Italy's abrupt economic contraction Aug. 8, as well as a prospective slowing in Germany's second-quarter growth rate.
Looking Up, Looking Down
Investment strategists say they expect the Fed's next move to be a rate hike, while the ECB seems more inclined to lower rates at least once over the coming year. That view caused the euro to sell off against the dollar on Aug. 8 and to weaken further on Aug. 11. The U.S. Dollar Index, a futures contract offered by the New York Board of Trade that reflects the dollar's standing vs. other major currencies, rose 0.37% to 76.125 on Aug. 11 after jumping nearly 3.3% during the week that ended Aug. 8.
"[T]he U.S. dollar's recent rise is largely attributable to market expectations of a bottom in U.S. short-term interest rates, coupled with a diminishing likelihood of further ECB tightening," Alec Young, international equity strategist at Standard — Poor's Equity Research Services, wrote in an Aug. 8 note, citing a significant rebound in the dollar against the euro, yen, pound sterling, Canadian dollar, Swedish krona, and Swiss franc from the low of Mar. 17, 2008, when it recorded a 6.7% year-to-date decline.
Currency strategists at Brown Brothers Harriman were quick to declare in an Aug. 8 research note that the dollar's multiyear downtrend was over, having completed the process of "carving out a bottom."
Citing the ridiculous heights that technology stocks reached in the late 1990s and in 2000, the note predicted, "we are going to look back with a similar bemusement at the pound trading at $2.10 and the euro above $1.60 and the Australian dollar near parity with the U.S. dollar."
Sell into Euro Rallies?
The rebound in the dollar has been driven by momentum traders rather than by longer-term institutional investors, who have not yet begun to reverse their bets against the dollar, says Meg Browne, senior currency strategist at Brown Brothers Harriman, in an interview with BusinessWeek.com. She cited data on speculative positions at the International Money Market in Chicago for the week ended Aug. 5.
"I don't think people have bought into the idea that the dollar is in a longer-term trend upward against the euro," Browne says. "This is a process that will take a while." Although the euro has put in a top just above $1.60, the currency is likely to attract some buying in response to this week's gross domestic product figures for key euro zone economies, Browne predicts.
With the euro breaking below the bottom of a four-month range at $1.5285 on Aug. 8, Browne suggests using corrective rallies in the euro to begin establishing longer-term euro short positions.