- The Washington Times - Friday, December 18, 2009

Souring economic prospects in Europe have helped halt the dollar’s months-long decline, enabling the greenback to rise to unexpected heights against the euro this week in line with signs of strength in the U.S. economy.

It was not good news for shareholders, though. The dollar’s rise to a three-month high Thursday helped push down stocks worldwide because investors had placed leveraged bets that depended on a further weakening of the dollar.

The dollar’s dramatic drop of 13 percent against the euro and other major currencies earlier this year was due in large part to the widespread belief that U.S. recovery would lag the rest of the world. But analysts said the dollar would revive as investors awakened to realities such as the troubles in Europe that were highlighted by a downgrade of Greece’s credit rating by top Wall Street ratings agencies this week.

“For the beleaguered U.S. dollar, there is light at the end of the tunnel,” said Karl Schamotta, market strategist at Custom House, a Canadian foreign exchange firm, who noted that “cracks are appearing” in the veneer of economic strength seen in Europe earlier this year.

Besides Greece, Italy, Portugal, Spain and Ireland all are mired in recession and contending with major debt burdens. With growth in the U.S. near 3 percent since this summer, “growth rates are rapidly diverging” and unmasking fault lines between countries that are poised to take advantage of the worldwide economic resurgence and those that are still foundering and grappling with overwhelming debts amassed during the financial crisis.

U.S. budget deficits have soared above $1 trillion since the crisis began, raising alarm in some quarters, but deficits also have burgeoned in Europe, where most countries had large deficits before the crisis, leaving the weakest ones now barely able to cope with their debt loads.

“Greece, Italy, Portugal, and Spain are at risk of defaulting on their debts,” as they are not benefiting from a revival of their economies like the U.S. and other stronger countries, Mr. Schamotta said. Their troubles are putting pressure on the common currency, the euro, even though major European countries like France and Germany are experiencing economic recoveries.

The diverging outlook between the U.S. and Europe was also highlighted this week as the U.S. Federal Reserve, citing recent improvements in the economy, announced that it would end several emergency programs it set up last year to nurture stricken credit markets. Analysts say the path toward economic and financial normalcy will not be so easy for the Fed’s European counterpart.

“With the European Union’s economic strength being the same as that of its weakest link, the political challenges are immense,” Mr. Schamotta said.

“While the U.S. Federal Reserve is able to begin removing liquidity and raising interest rates as growth returns over the next year, the European Central Bank will be constrained by the pace of growth and debt levels in the weaker member nations. This means that interest rate differentials are very likely to begin widening over the next year, supporting the U.S. dollar and applying negative pressure on the euro.”

Nick Bennenbroek, currency strategist with Wells Fargo, said the dollar really began to take off after a jobs report on Dec. 4 showed a vast improvement in the labor market after months of big layoffs. He sees further strengthening of the dollar next year as economic realities continue to settle in and blow away distortions caused by “the explosion of a dollar-funded” leveraged buying spree in stocks, commodities and other riskier investments worldwide.

That so-called “risk trade” or “carry trade,” where investors take out low-interest loans in dollars and invest the money in countries where currencies and stocks are appreciating, has been the major factor driving down the U.S. currency since March, overwhelming indicators of economic strengthening and trade balance that normally have the greatest influence on the direction of the dollar, he said.

With the markets now responding to the return of growth and more normal economic and financial conditions in the U.S., he said, another factor should provide further substantial support to the dollar in the months ahead: the dramatic narrowing of the U.S. trade deficit from over 6 percent of economic output at its peak to around 3 percent today - the same level where it was in the late 1990s when the dollar was in a strong rally.

Once investors awaken to these fundamental improvements, they could start pouring into the U.S. currency again, he said, and they will be further attracted by the dollar’s historically “cheap” level at 8 percent below its 20-year average. The euro bought as little as $1.4338 in late New York trading Thursday, dropping to its lowest level since early September.

Steven Englander, a strategist at Barclays Capital, which has been a major proponent of the “carry trade” driving down the dollar, said he’s not convinced that anything major has changed to support the currency. The Fed is still expected to keep interest rates near zero until next September, making it “safe” to bet against the currency and invest outside the country for a while longer, he said.

But he agreed that markets are responding to concerns about economic instability raised by Greece’s troubles and the recent near-default of a Dubai-owned company. Long considered a safe-haven currency in times of trouble, that has caused the dollar to gain against the currencies of weaker developed and emerging countries.

Because Greece uses the euro, its troubles have put pressure on the European currency. But Barclays points out that the euro continues to benefit from a trend among the world’s central banks of putting a greater share of their reserves into euros to diversify out of the dollar.

“It is very unlikely that the more dire outcomes being discussed will materialize” as a result of debt problems in Europe, he said, but “euro weakness is probably one of the few benign consequences of these emerging fiscal concerns.”

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