All Hail the Almighty Dollar!

03/05/2009 2:39 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

If there’s one idea that’s almost universally held in the investment community, it’s that in the long run, the US dollar is toast.

The greenback has rallied nicely in the last few weeks against both the euro and the collapsing Japanese yen, which fell to a three-month low against the dollar last week. The British pound is also trading near its recent lows against the buck.

Temporary factors may be at play here. Foreign banks need dollars to roll over their short-term obligations.

Hedge funds will still have to meet outstanding redemption requests in dollars. And as the Japanese economy went into freefall, the yen ceased to be a haven from risk, and the dollar, in which Treasury bonds are denominated, jumped into the vacuum.

Almost none of the commentators I read, however, expect that to last. They say that all the government bailouts and stimulus plans and billions upon billions of dollars in future deficits ultimately will unleash a flood of money that will create hyperinflation and spark a run on the greenback.

But as we know, when everybody agrees on something, they’re usually wrong.

I think we have a long, long way to go before inflation becomes a problem—and when it does, we know how to fix it. And, the blame-America-first crowd aside, other countries’ and other currencies’ problems are simply worse than our own.

That all points to a stronger dollar for longer than people expect-at least for the next year.

“Every currency has pressure on it,” says Nicholas Vardy of Hayek Capital Management in London and editor of Global Bull Market Alert. The dollar is “the ‘least worst’ of all of them,” he adds.

Why? Well, first of all, the Federal Reserve has thrown a lot of money into the bailout of the financial system—$2.1 trillion spent so far, with many trillions more in reserve in loans, investments, and insurance, according to The New York Times.

But the vast majority of that extra money won’t be spent, thank God; a lot of it comprises backstops and guarantees.

And the debt hole all that money has to fill now may be deeper than we think. Nouriel Roubini and Elisa Parisi-Capone of Roubini’s firm RGE Monitor, estimate that “an additional $1.4 trillion of capital is needed to restore the banking system to its pre-crisis capitalization levels.”  So, we’ll need to pay off the debt and shore up banks’ balance sheets before the money spills over into inflation.

And as Vardy points out, it takes more than just a big pile of cash to create inflation. He goes back to the old formula inflation = the amount of money x the velocity of money (a measure of the number of times per year each dollar is spent). All that money has to be circulating to generate inflation, and that’s simply not happening.

“If bankers are sitting on the money and people are not spending, the velocity is [decreasing,]” he says, and we’ll have to get back to normal lending for that to change.

The verdict: There’s no way inflation will come back until we fix the banks’ debt problems—and that won’t be soon.

And when inflation rears its head again, we know how to fix it. Within our lifetimes, we’ve seen Federal Reserve chairman Paul Volcker stop inflation dead by raising interest rates as high as they need to go. That’s what every Fed chairman will do from now on. And, by the way, higher rates usually boost the dollar.

Plus, the dollar has little competition among major liquid world currencies these days. The United Kingdom is probably worse off than we are—with a banking system on the brink, an even bigger housing crisis, and a far less diversified economy. That’s why investor Jim Rogers recently declared: “The UK has nothing to sell.”

It’s also why the pound has lost a third of its value against the dollar since late 2007, as it traded around $1.40 recently. And Kathy Lien, directory of currency research for Global Forex Trading, thinks it may fall some more.

The Japanese yen had been a pillar of strength for the last few months, as investors bought yen to hedge against market risk. But Japan’s gross domestic product dropped 3.3% in the fourth quarter, while exports plummeted a sickening 45.7% in January. No wonder $1.7 trillion yen (nearly $20 billion) fled the country in one week. Who wants to stay aboard this sinking ship?

Which brings us to the euro. Having soared to around $1.60 last summer, the unified European currency now trades at about $1.25—a 20% decline (see chart, reprinted with permission of GFT).

The euro zone itself is suffering some strains as peripheral economies—notably Portugal, Ireland, Greece, and Spain (the PIGS countries, in Vardy’s phrase)—have been hit hard by the financial crisis.

But the real crunch may be looming just ahead—in central and eastern Europe. Several of those countries already have joined the European Union, and Poland and Hungary have expressed interest in adopting the euro. 

Problem is, emerging Europe is going through a crisis of its own, brought on by the kind of borrowing mania that walloped Asia and Latin America in the past. 

According to Moody’s, Eurozone banks have $1.5 trillion in liabilities in central and eastern Europe. US banks have little exposure. Was it just dumb luck or did they actually learn from previous mistakes?

Whatever, it’s a dark cloud hanging over the euro, which Vardy estimates is still 25% overvalued on the basis of purchasing power parity, the so-called “Big Mac” index or how much a Big Mac costs in different countries.

Lien pretty much agrees. “I think the euro is going to break $1.25,” she says. And although there’s little chance the euro could dissolve, it could go much lower.

She thinks the greenback’s recent rally may be a little long in the tooth, and she thinks the dollar index (a measure of the dollar’s strength against six major currencies) may retreat a bit from its current level around 89. Support is around 85 and resistance is at 92-93, she says.

I think it could challenge those highs as investors increasingly look stateside for risk protection. That may sound ironic given the mess we’re in, but everybody’s in a leaky boat, only some boats have bigger holes than others.

Whatever you think of the Obama administration’s efforts to stimulate the economy and rescue the financial system—and I have a lot of reservations about what we’ve seen so far—investors and traders are giving the US credit for bailing the water over the side faster than some of the other wounded craft in the sea.

I know that doesn’t sound like much, but it’s probably enough to keep the greenback afloat for a while.

Howard R. Gold is executive editor of Moneyshow.com. The opinions expressed here are his own.

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