The dollar ended Wednesday's New York session near a 14-month high against the euro and an 11-month high against the yen. To many, the risks appeared increasingly tilted to the downside for the greenback. Indications of revived U.S. economic strength and expectations for more -- including a likely boost from the upcoming employment report on Friday -- have already been built into current levels, as have prospects for more

Federal Reserve

rate hikes.

The dollar's short-term vulnerability was reflected in the immediate aftermath of Thursday morning's news of the terrorism bombings in London. In early trading, the euro rose above the $1.20 level vs. $1.1928 late Wednesday while the Swiss franc gained about 1% vs. the greenback. Although the dollar did rally vs. the British sterling, "the speculative community was clearly long dollars coming into today's session, and this event has clearly forced out some of the late dollar longs," observed

RealMoney.com

contributor Marc Chandler. "But unless the market concludes that the Fed's monetary tightening cycle will be interrupted by the impact of today's event, the dollar will likely regain its footing."

Indeed, little appears to be in the way of the dollar remaining strong in the near term and the greenback was on the comeback trail by midmorning; in recent trading, the euro was trading at $1.1938.

"The Fed's tightening cycle still seems intact after today's attack in London. Financial incentives, like the relative and absolute level of U.S. interest rates and the shape of the yield curve, favor additional dollar gains," Chandler commented in

RealMoney.com's

Columnist Conversation. "Today's euro high is likely to take on psychological significance and probably denotes the upper end of its trading range. As the situation in the U.K. becomes clearer, further dollar gains are likely. "

Not surprisingly, then, worries about the dollar's ongoing

bite into corporate profits are mounting. As the market prepares for the second-quarter earnings season, those concerns have topped the impact of higher energy costs, says Barry Hyman, equity strategist at Ehrenkrantz King Nussbaum. "It's becoming a major concern." (Granted, crude's record close on

Wednesday was a big factor in the stock market's decline.)

Last Friday,

Oracle

(ORCL) - Get Report

confirmed those fears, warning that the dollar's strength has already eaten away 2% of its revenue for the year. The day before,

Red Hat

(RHAT)

also indicated similar concerns.

Vadim Zlotnikov, market strategist at Sanford C. Bernstein & Co., says the dollar's strength has forced him to trim his portfolio allocations in technology stocks, to delay allocations into pharmaceuticals, and to focus more on domestically sales-oriented -- or European cost-based -- vendors. For instance, he recently deleted

Hewlett-Packard

(HPQ) - Get Report

and added

Circuit City

(CC) - Get Report

to Bernstein's core portfolio.

"The strong dollar is likely to drive earnings misses and further underperformance by U.S.-based companies with large international sales," Zlotnikov wrote in a note to clients. "During the past three months, companies with large international exposure underperformed those with large domestic sales by 5%."

And should the dollar remain strong or continue higher, risks are mounting for third-quarter and especially fourth-quarter earnings, he says.

Greenback Comeback

The case for current dollar strength was first overlooked by most observers. The huge structural imbalances created by the ballooning current account and trade deficits were expected to keep weighing on the greenback, as they did last year. The weakness of the euro was also unexpected.

Yet halfway through 2005, the U.S. economy still offers the most compelling growth story compared with Japan and Europe. And as long as the outlook for interest rates here remains tilted to the upside, the greenback remains immune to the U.S. economy's structural imbalances, according to Ashraf Laidi, currency strategist at MG Financial Group.

"Sustained rate hikes have been the main support behind the dollar's strength," says Laidi.

He believes that eventually, increased evidence of a slowing U.S. and global economy, as the existing rate hikes and the surge in oil prices start to take a toll, will lead to such a pause.

"This would be enough for the dollar's rally to halt," Laidi says. "The next leg down would be as the trade deficit, which has fallen off of the radar lately, comes back in the picture."

In addition, the dollar's bite into earnings and the dull performance of U.S. equities could make the greenback bite its own tail, deterring further flows into U.S. assets. Foreign capital inflows have been decelerating in recent months and were not enough to cover the current account deficit in the past two months.

But in the near term, the dollar remains supported and can even continue moving higher, Laidi says. Even prior to the bombings in London, the meeting of G8 countries this week in Scotland was not expected to yield new developments in the potential revaluation of the Chinese yuan, a move that would likely prop up most Asian currencies against the greenback.

With the talks centering on poverty and Africa, foreign exchange "is not expected to be a major talking point," says ABN Amro global currency strategist Tony Norfield.

The dollar has found new wings since last week when the Fed said inflation pressures "remain elevated" and provided no indication that it intended to lift its foot off of the monetary-tightening brake anytime soon. Heading into Thursday's policy meeting -- where it left rates unchanged -- the European Central Bank, or ECB, indicated that it had no intention of cutting interest rates in the euro zone, rejecting pressures to do so from the European Parliament. The Bank of England, or BOE, also left rates unchanged at its policy meeting Thursday, as expected.

"The impact

of the bombings on the U.K., disruption of business and perhaps a knock on the already softening economy may make a

future BOE rate cut more likely, but the market had already gone a long way toward pricing in a 50 basis point rate cut by the end of the year," Chandler observed. "The ECB is a different matter.

ECB President Jean-Claude Trichet, repeating the mantra, says interest rates are appropriate. This disappoints some looking for some sign that a rate cut is not completely ruled out."

Meanwhile, the Fed appears primed to keep tightening, meaning the rate differential between the dollar and the euro will continue to widen in the dollar's favor.

The dollar has also received a boost from recent economic data, including the Institute for Supply Management's manufacturing and service surveys, consumer confidence data and a rebound in factory orders for May.

On Friday, the mother of all economic reports -- the June employment report -- is expected to show a strong rebound in new payrolls after weakness in May. Consensus forecasts range from 180,000 to 200,000, and whisper numbers are running as high as 240,000.

"That could spell the

near-term death of the euro, if we get a number well above 200,000," says Laidi. The euro, he says, could fall to $1.18 from its current level of above $1.19. The euro was trading at 1.1926 early Thursday vs. $1.1931 Wednesday.

Conversely, a surprisingly low payroll number, say 140,000, could spark a dollar selloff. Beyond these numbers, the next real test for the dollar will come from trade data on July 13 and Fed Chairman Alan Greenspan's semiannual testimony on July 20.

Many market players had expected the Fed to provide at least a hint last week that it may consider taking a pause in its rate hike campaign. Now many are betting that such a hint remains a distinct possibility, with Greenspan having more room to expand on the theme during his testimony.

Should that hint materialize, the dollar's strength would start to wane, and that would provide relief for U.S. corporate earnings. But any such move will be too late to aid forthcoming second-quarter results, which may prove disappointing as the greenback's strength so far this year has surprised most analysts.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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