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If the Treasury won't do anything to protect the plummeting U.S. dollar, will the

Federal Reserve

? Judging by the stock market's performance Monday, the smart money thinks not.

The dollar crashed through record low levels vs. the euro Monday, even as the

Dow Jones Industrial Average

surged about 1% to an 18-month high of 9,965. All the action came one day before the Fed's policy-making arm meets to decide on interest rate policy Tuesday.

Both rock-bottom interest rates and a weak dollar have come to be viewed conventionally as near-term bullish for stocks, and it is safe to say Monday's market action suggests traders are optimistic neither is about to change. The


added 0.6% to 1,949, while the

S&P 500

added 0.7% to 1,069.

The Treasury has repeatedly professed a "strong dollar" policy this year but has done little tangibly to prevent the currency's depreciation. Back in January, Morgan Stanley economist Stephen L. Jen argued that Treasury Secretary John Snow had adopted a "de facto" neutral dollar stance in an effort to allow the dollar's value to correct vs. the euro and the yen. Jen also argued in May that until the euro/dollar exchange rate reached 120, no credible effort to stabilize the dollar would materialize.

Now that the euro's risen to about $1.22, Jen thinks other parties might be heard from. "The G3 likely will take action on the U.S. dollar," he said, referring to Japan, Europe and the U.S. Jen expects that the dollar could bleed as low as $1.25 per Euro before rebounding.

There are three things the G3 can do to bring the dollar back up. First, national treasuries could simply buy dollars in the open market. Second, central banks outside the U.S. could cut interest rates and/or the U.S. Federal Reserve could raise them. And third (and by far the least likely), the federal government could put its fiscal house in order and stop printing money to finance an expanding budget deficit.

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In the near term, nobody seriously expects the Federal Reserve to raise interest rates to defend the dollar -- or for any other reason. So the responsibility for preventing a full-scale collapse is going to fall to the U.S. Treasury, the Europeans and the Japanese. Jen says that the Japanese will likely accelerate their dollar buying immediately, while the Europeans will start with tough talk followed by cutting interest rates and controls on capital movement.

At $1.22 per euro, the Europeans are going to be missing out on substantial export sales, and will be looking for Secretary Snow to stop winking the next time he talks about a strong dollar.

Meanwhile, the weakening dollar has been a boon to U.S. manufacturers such as Dow component


(CAT) - Get Caterpillar Inc. Report

. Smith Barney analyst David Raso upgraded the stock Monday to buy from hold, citing the weak U.S. currency as contributing to Caterpillar's sales in Asia, Europe and Latin America. With the U.S. entering an election year and American manufacturing jobs still being shredded, neither U.S. companies nor the current administration are anxious to see the dollar appreciate much from here.

Still, economists would like some signal that the currency's free fall will be stemmed. If it can't be, "it seems reasonable that foreign investors would finally demand compensation for taking currency risk on dollar-denominated assets -- pushing long-term U.S. real interest rates higher," said Stephen Roach, chief economist and director of global economic analysis at Morgan Stanley. He also cites the U.S.' big current-account deficit, which will require $3 billion per day in capital inflows to the U.S. by 2005 as likely to drive interest rates up.

Real demand for U.S. dollars is going to have to rise, but the Federal Reserve has signaled that it is not going to bail out the Europeans by raising U.S. interest rates, particularly not at the expense of the domestic economy. After the relatively weak job numbers from last week, it is a near certainty that the Fed will not only keep rates at 1%, but will continue to signal that it has no intention of raising them anytime soon.

What happens in the bond market is another question. While demand for U.S. government debt has been strong all year, the U.S. Treasury is gearing up to borrow as much as $600 billion this year to finance the federal budget deficit. The Treasury announced today that this week it will float $28 billion in new five- and 10-year notes. The news drove yields on the 10-year Treasury nearly 5 basis point today, to 4.28%.

And the economy is undeniably strong, even if the jobs report showed a slower-than-expected increase in hiring. In one of the most important indicators of consumer spending,


(WMT) - Get Walmart Inc. Report

said Monday it expects to meet its forecast for a 3% to 5% increase in December sales.

Ultimately, while paying lip service to pricing-power concerns, Chairman Alan Greenspan won't wait forever before taking precautions against inflation. Bank of America Securities analysts are advising their clients not to wait around for the inevitable interest rate hike, whenever it ultimately comes. They cut their recommended equity portfolio allocation down 5 percentage points saying that "the 2003 rally has spoiled the extraordinary opportunity that existed a year ago when stocks were at the low end of their long-term trend."