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Where's the Dollar Headed?: Analyst's Toolkit

Currency investing is complex, especially when there are temporary shocks like the European debt crisis.

BOSTON (TheStreet) -- Currency investing is the most esoteric in all of finance. Many investors are lost when trying to determine the probable path of the dollar or euro.

Since the beginning of December, the dollar has risen against the euro as concern about sovereign debt in weak European Union countries including Greece, Spain and Portugal spook investors and send them running for safety. The strength of the dollar will likely dissipate in the coming months, provided the steps taken to save the troubled PIIGS (Portugal, Italy, Ireland, Greece and Spain) prove to be adequate.

Besides temporary shocks, currency movements can be influenced by expectations for inflation. The relationship between currencies and anticipated inflation is referred to as purchasing-power parity and can be approximated by simply subtracting one inflation rate from another.

For instance, the current dollar/euro exchange rate is about $1.27/1 euro. If inflation expectations were 3.5% in the U.S. and 2% in the euro-zone, the dollar would be expected to depreciate against the euro by about 1.5%, meaning the exchange rate would climb to about $1.29/1 euro.

That measure, however, takes a long time to be realized. It's a good tool for projecting long-term currency movements. Money flows and economic growth are two other factors.

Many investors base their projections on relative economic strength. This theory says that countries with strong economic growth will see increasing investments from overseas as investors hunt for better returns. The strength of the economy attracts investments, and the currency appreciates as the money flows into the country. For the U.S., this would be seen through investments in American companies like

Caterpillar

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,

General Electric

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and

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Apple

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.

The Treasury releases what it calls U.S. Foreign Net Transaction data, which can help quantify flows. This metric hit a two-year high of $126.4 billion in November, but has declined since then and is now at $47 billion, less than its long-term average of $56 billion.

Investors with currency exposure should consider reducing dollar holdings if the flows begin to fall or turn negative. Right now it appears there is some support for the strong dollar since cash is still coming into the country in greater amounts than it's flowing out, but that trend could reverse itself quickly if European economies start to look stronger.

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Another tool to measure currencies is yield curves. With rates being held to low levels, capital flows are likely to be strong since the environment for investing is conducive to growth since money is cheap. Much like relative strength, this metric focuses on an attractive investment opportunity to pull in cash from abroad. Currently, with the fed funds rate at basically zero, international investors are probably eyeing the U.S. as fertile ground to invest in huge companies like Caterpillar and GE, which can access capital cheaply. The U.S. Foreign Net Transactions number should also point to this situation being real.

Finally, the U.S. savings rate can also have an impact on foreign flows. The idea behind this theory is that as growth climbs, the savings rate will need to rise as well to fuel the investment. If that doesn't happen, capital will need to flow in from foreign sources to fill the gap.

Currently, the U.S. savings rate is above its long-term average, but it's been falling in recent periods, suggesting there's less growth being fueled by domestic sources and more need for foreign investments that will push up the dollar.

All signs are pointing to a strong dollar, thanks mainly to the country's low rates, rebounding growth and Europe's debt crisis. This won't last forever.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.