What Could Lift the Dollar?

The most recent employment data in the U.S. came in significantly better than what was expected. And the financial markets reacted in a different way this time. Interest rates went screaming higher, the stock market surged, gold fell and the dollar shot up.

In a normal environment a stronger dollar following better U.S. economic data sounds perfectly reasonable, but in the current “risk-centric” environment good news has been bad news for the dollar. That’s because it has emboldened risk appetite, which has translated into investors selling dollars in exchange for higher yielding/higher risk currencies.

This time the improving data gave investors the idea that the Fed could begin reversing its zero interest rate policy sooner. That got the dollar moving higher. And that got the wheels turning for a bounce in the weak dollar trend.

The dollar has continued to show strength following that turn in sentiment, but the prospects of a sooner move on rates has now been dismissed. The knee-jerk reaction in the markets that priced in an earlier hike in rates was subsequently fully reversed.

What is now underpinning dollar strength is a shift in market focus toward some of the headwinds facing the global economic environment. That’s swinging the risk appetite pendulum back toward safety, which is positive for the dollar.

So what can keep this momentum going in the dollar?

Answer: Growing risks to the global economy.

Let’s take a look at some of the specific catalysts that could fuel more demand for dollars …

Catalyst #1: Rising Prospects of a Sovereign Debt Crisis

First it was Dubai that stoked fear in the financial markets over the Thanksgiving Day holiday. Now, Greece has been called on the carpet over concerns that the nation will struggle to meet debt commitments. Fitch downgraded Greece to just three notches above the lowest investment grade status.

Debt problems in a global crisis have the ability to be contagious. And that can destroy investor confidence in the capital markets of such countries, and in the global economy. And when confidence wanes, capital flees. That’s a recipe for falling dominoes.

First it was Dubai that rattled the markets. Now Greece’s debt has investors worried.

Catalyst #2: Problems for the Euro

The recent downgrade in Greece turns the market focus back to the problems that exist in the Eurozone, and that’s putting downward pressure on the euro … which means upward pressure on the dollar.

The European Union’s growth and stability pact limits all member countries to a budget deficit of 3 percent of GDP. But Greece is running a budget deficit of 12.7 percent of GDP, over four times the limit.

In fact, on average, the 16 member states of the single currency are running a budget deficit more than twice the 3 percent limit!

So the uneven performance in Europe will likely call into question the viability of the euro currency again. Another bout of speculation of a break-up of the euro is hugely dollar positive.

Catalyst #3: Growing Uncertainty Surrounding Economic Recovery

Now that sovereign debt problems are surfacing, investors are getting concerned about the sustainability of this recovery. After all, the unprecedented global fiscal and monetary response was an experiment. The outcome is unknown. And the underlying problems related to the crisis still exist: Bad debt, reduced wealth and tight credit to name a few.

Moreover, when you answer a liquidity crisis with more liquidity, you’re bound to create more bubbles. While ground zero for the credit crisis was the U.S. housing market, new bubbles in real estate are developing in the areas that were relative outperformers in the downturn (such as China, India and Canada).

In Shanghai, housing prices were up 40 percent in October from the same period a year earlier. And in a story about the Canadian housing market this week, Bloomberg quoted a real estate agent as saying, “Where else in the world do you have agents lining up overnight to buy a condominium?”

To someone here in the U.S., that sounds familiar.

Catalyst #4: Protectionism

We’ve already seen evidence of restrictions on global trade and capital flows. Considering protectionism was a key accomplice in fueling the Great Depression, this activity represents a major threat to global economic recovery.

After the lessons from the Great Depression, the leaders from the top 20 countries of the world vowed to avoid protectionist activity. But actions from the G-20 countries are speaking louder than words. New trade restrictions have been erected by most of them since the pledge was made.

Trade restrictions could derail global economic recovery.

Perhaps the biggest factor in the protectionism threat is China’s currency policy. Even after recent tour stops in China by U.S. President Obama and European Central Bank President Jean-Claude Trichet to lobby for a stronger yuan, the Chinese have remained steadfast on keeping their currency weak. As this issue with China’s currency gains in intensity, expect protectionist acts to rise in retaliation. And expect collateral economic and political damage.

Bottom line: If sovereign debt problems and the prospects of a double dip grow, you can expect investors to pull in the reins on risk. And this time, they might not be as eager to turn the risk appetite switch back on. That could give the buck a strong lift … a lift that might last longer and rise further than many expect.

Regards,

Bryan

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