THE U.S. DOLLAR RALLY: WHAT INVESTORS SHOULD BE WATCHING

Currencies January 20, 2010, 7:33PM EST

After months of gloomy talk, the currency is mounting a surprising rebound. The health of the U.S. recovery will be key to its continued strength

A couple of months ago, the U.S. dollar wasn't going to win any popularity contests. Currency markets reflected worries that the federal government's debt burden was too heavy, the American economy too damaged, and U.S. interest rates too low to support the currency over the long term.

Now, it appears, the buck is back. The U.S. dollar hit its highest level against the euro in five months on Jan. 20. The euro trades at $1.41, 10¢ below its peak in late November.

The dollar index—measuring the greenback against a basket of international currencies—hit its highest level since September, trading at 78.36.

It's not as if all the worries about the U.S. dollar have evaporated in the last couple of months. Markets reflect various currencies'—and various economies'—relative strengths.

As recently as November, the dollar was taking a "psychological beating," says Brian Dolan, chief currency strategist at Forex.com. But it has bounced back on good U.S. economic news and bad news from Japan and Europe, he says.

"While the U.S. recovery isn't perfect, it's progressing faster than the Japanese and European recoveries," says Alexander Young, international equity strategist at Standard & Poor's.

Wounded Euro

Few developed economies have a cheery story to tell these days. Europe, in particular, has been hurt by worries about the fiscal situation in euro zone members like Greece. Last month, all three major international credit rating agencies lowered their assessments of Greece's government debt.

"It's almost like a race between the walking wounded," Young says.
A weak currency might sound like a bad thing, but in fact it can aid economies in distress. "When we're having economic troubles, the weaker dollar helps," says Mike Rourke, chief market strategist at brokerage BTIG.

A weak dollar, for example, makes U.S. companies' products and services more competitive on a global basis. (And a strong euro has hurt European exporters.) A cheaper greenback also boosts overseas profits for U.S. companies with large international operations.

For investors, the impact of swings in the dollar can be significant. "If the dollar weakens, it's good news for U.S. investors because they make more money in their foreign investments," notes Michele Gambera, chief economist at Ibbotson Associates, a subsidiary of Morningstar (MORN).

Critics of President Barack Obama blame his fiscal policies for the weaker dollar, but Gambera calls this analysis "politically motivated." He notes the dollar has been losing strength against the euro since late 2000, when the greenback was worth 70.5% more than today. Even after the recent rebound, the dollar is undervalued against other industrialized currencies, Gambera says.
Dollar Could Rise Further

Those bullish on the U.S. dollar believe its relatively low value and improving U.S. economic prospects give it further room to rise. American companies and the U.S. economy are reaping the benefits of a weaker currency, says Geoffrey Pazzanese, portfolio manager at Federated Investors (FII). That makes the U.S. a more attractive place to put money, especially compared with Japan and Europe, he adds.

"As we reap the benefits [of the dollar's decline over the last decade], there will be pressure on the dollar to appreciate over time," Pazzanese says.

The dollar's rally could stall if traders detect a weaker-than-expected U.S. economic recovery or continued worries about the U.S. debt burden. "Everybody is going to be watching the deficit," says Uri Landesman, portfolio manager at ING Investment Management (ING).

For investors, the weakening dollar in 2009 coincided with a rising stock market. But, as the dollar has strengthened, U.S. equities have continued to do well. "It's almost a win-win [situation] for equity investors," Young says. A weaker dollar makes U.S. exports more competitive and boosts overseas profits, while a rising dollar reflects optimism about the U.S. economy. Both help stocks, he says.

The movements of currencies over the short term are very difficult to predict, despite the big effect that currency swings can have on investor portfolios.

Emerging Markets' Appeal

For those trying to invest for the long term, currency experts advise seeking out high-quality investments in countries where strong economic growth is expected.

"You want to look at where the economic growth is going to be in the next five to 10 years," says Georgetown University finance professor Reena Aggarwal. "You want to make sure you have exposure to those parts of the world."

That's why many investors are favoring fast-growing emerging economies, she says.

If the emerging-market bulls are right, the dollar's ascendancy vs. its traditional peers, the euro and the yen, may not mean as much this time around, as the currency arena has more heavyweight participants. Countries like China, India, and Brazil could be the next to gain prominence in the clash of global currencies. Still, the buck's current strength signals that, for now, the dollar's status as the world's supreme currency is intact and the U.S. economic recovery is on track.

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