Dollar Could Surprise In 2010

Investors should expect the currency to rally in the coming months.

The dollar/euro rate has surged from a low of around 1.25 in early 2009 to over 1.50 today, almost regaining its 2008 peak and renewing speculation that the dollar is facing sustained devaluation. While this cannot be ruled out, and the dollar faces formidable short-term pressure, there are good reasons to expect a rally over the next six to nine months. Investors who continue to short the currency in 2010 face considerable risk.

Dollar cycle. The current round of dollar weakness follows a strong rally during the peak of the financial storm, in a well-rehearsed pattern of dollar cycles:

--The rally under former President Ronald Reagan from 1980 took the dollar up by as much as 40-60% (based on a weighted index that varies according to the currency basket used) before the Plaza Accord punctured the bubble in 1985-86.

--The "strong dollar" rally under former Treasury Secretary Robert Rubin (the "Rubin rally") of 25-30% from the late 1990s up to 2002 came amid optimism over a strong U.S. growth outlook.

The dollar cannot be seen as a one-way bet. Indeed its latest rally took it from 1.60 dollar/euro in mid-2008 to 1.25 in early 2009.

The euro. The euro is not a driver of the dollar. On the contrary, dollar sentiment drives the euro as European bonds are the main alternative to holdings in the liquid U.S. bond market. The euro is rising on dollar flight, moving rapidly from around 1.25 in the crisis period of early 2009 to its present rate of 1.50. Its latest surge, and the threat of rising ECB interest rates, is problematic as the E.U. economy is still struggling to emerge from the global recession, with world trade down some 20% from peak.

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