Four Reasons the Buck Should Stay Strong

10/29/2008 1:00 pm EST

Focus: MARKETS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Vardy’s Global Stock Investor, tells why he thinks the dollar’s recent rally is for real—and why it will continue.

Besides the sudden and remarkable collapse of global stock markets in the past month or so, the biggest surprise in global financial markets has been the continuing rally in the US dollar.

Here’s why I expect the US dollar’s rally to continue.

First, the popular “decoupling theory”—the belief that the rest of the world’s economies can continue to thrive while the US economy slows—is bunk. The potential negative effects on the dollar of the $700-billion rescue package passed by the US Congress took a back seat to investor concerns about the woes facing the European financial system.

Just as Europeans began to celebrate the demise of US-style capitalism, it was announced that the 13-nation euro zone economy shrank 0.2% in the second quarter—the first decline since before the euro’s introduction in 1999. The European Central Banks recent emergency rate cuts notwithstanding, European economies are likely to stagnate [for] the foreseeable future. And the additional fiscal burden of the European banking rescue package will put further pressure on the euro.

Cross the channel to the United Kingdom, and you find a bigger housing bubble and an even greater consumer credit problem than the US has. That’s why the UK, with its pound sterling currency, has every reason to continue its status as the currency markets’ newfound whipping boy, even as the country is likely to enter a recession.

Second, the US fiscal position as a percentage of GDP is not nearly as bad as the headline numbers would indicate. Adding the $700 billion of the rescue package to the US fiscal deficit in 2008 as some financial journalists are doing is inaccurate.

By all accounts, the bulk of the $700 billion will be used to buy assets or perhaps stakes in US financial institutions, including substantial stakes in US banks. The greatest irony would be that the US government actually makes a profit on the Paulson rescue plan—what Andrew Kessler in The Wall Street Journal called potentially the greatest hedge fund trade ever.

Third, on measures such as purchasing-power parity, the US dollar still looks cheap against the euro, the Swedish crown, the Swiss franc, and the UK pound sterling. It’s an iron law of economics that over the long term, currencies return to something approaching purchasing power parity. Notwithstanding its recent rally, the US dollar is substantially undervalued against all major developed countries’ currencies except the Japanese yen.

Finally, the events of the past month confirm that when investors seek liquidity and safety, they still turn to the US dollar. That alone will ensure that the greenback will continue to rally even in the midst of global financial turmoil.

The US dollar remains the world’s reserve currency. And the dollar’s recent resurgence as the ultimate safe haven asset is also likely to put to rest for now talk of global central banks and other large holders of reserve assets diversifying out of the US dollar.

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