Why Has the Dollar Rebounded - And When Will It Correct?
The dollar has continued to maintain strength relative to many foreign currencies since the collapse of U.S. financial institutions. During the summer of 2008, the dollar was trading at close to $1.60 to the Euro and now, on November 24, it trades at close to $1.25 to the Euro.
The rapid ascent of the dollar caught many traders off guard. The cascading fall of major U.S. financial institutions such as Fannie (FNM), Freddie (FRE), Lehman (LEHMQ.PK), and AIG (AIG) was the catalyst that ignited the dollar rally. Panic permeated the economic climate, prompting many financial institutions and main street businesses to question the soundness of the global banking system. Panic stricken investors pulled their money out of their risk infested banks and found calmer waters by anchoring their money in U.S. treasury bonds. With so many foreign investors purchasing U.S. treasuries, the demand for dollars grew to the point we are at today, $1.25 to the Euro.
The strength of the dollar is the result of panic and what is called an event risk. When the event risk subsides and normalcy returns to global markets, the dollar will revert to the secular bear pattern of the past two years.
There is little fundamental reason for the dollar to maintain the strength through this event risk.The dollar should be in worse shape after the event risk than before it due to the massive deficit spending and the expansion of our federal debt.
Moreover, this crisis comes at an inopportune time, when our country will be facing larger and larger structural deficits due to the Medicare and associated retirement costs of the Baby Boomers. I would expect normalcy to start returning in 2009. probably around the early spring.
A catalyst to drop the dollar value might come from the recent announcement that China will spend $586 billion dollars to stimulate their slowing economy, which will most likely cause them to sell U.S. treasuries. This action should put downward pressure on the dollar.