How the Dollar Could Rally

There's a Wall Street maxim that the national news magazines often make great contrarian indicators. With a cover story titled "The Incredible Shrinking Dollar," the latest issue of Newsweek, therefore, provides an opportunity to ask a question that very few observers seem willing to contemplate: What could cause the dollar to rally?

Dispensing with the preliminaries, I'm aware of the dollar's long-term structural deficiencies, namely the current account and federal budget deficits. With the so-called twins seemingly getting bigger by the day, and more foreign central banks using the dreaded D-word ("diversification"), it is very hard -- if not impossible -- to make a long-term bullish case for the greenback. Indeed, we may be witnessing the early stages of the dollar losing its standing as the world's reserve currency.

But bear markets are often interrupted by ferocious rallies -- nine of the Nasdaq Composite's 10 biggest percentage gains occurred during its 2000-02 swoon -- so it's wise to consider some potential catalysts for a significant intermediate-term advance in the beleaguered buck.

"If there's going to be real strengthening of the dollar, it has to come from money leaving Europe" and the euro, says Dennis Gartman, publisher of The Gartman Letter.

The trigger for such a move may have arrived Friday when an opinion poll showed, for the first time, a majority of French citizens oppose the European Union constitution, on which they'll vote May 29. In recent trading, the euro was at $1.3282, vs. $1.3374 late Thursday.

The Dutch vote on the constitution on May 26 and a rise in opposition sentiment in either country could be "the next tipping point" for dollar/euro trading, Gartman says. "What happens if the Dutch or French vote down the constitution? Suddenly the EU ceases? It will be shocking to Europe."

Such an outcome -- or just the threat thereof -- could cause central banks to "realize they've made a mistake" in even contemplating a diversification of their reserves, says David Greenwald, a partner at Scalene Partners, a currency-focused hedge fund with over $100 million under management. "Such a scenario would create the most pain most quickly" for those short dollars and/or long euros.

Adding to the drama, Scalene's models show "we should be nearing a secular top in the euro," Greenwald says.

Yes, he said "secular" not "cyclical" -- adding a caveat that the euro's multiyear uptrend "could prolong itself for a series of months; the timing is where the value-added comes in."

Still, Greenwald admits believing in the so-called magazine indicator. "Articles like Newsweek's get the slow, follow-the-herd money to commit," he said, noting government and fund flow data show Americans are increasingly bullish on overseas assets, after the euro's roughly 40% appreciation. "Their dollars are buying less European securities but their interest is much higher."

The End of the Affair

Elsewhere, weakness in so-called riskier assets -- such as emerging markets and junk bonds -- could be a potential trigger for money flowing back into the U.S. Such assets were big beneficiaries of the "flight to risk" trade spurred by the Federal Reserve's easy money policies after the bubble burst and 9/11. The result was huge gains in some emerging market assets and (until very recently) record low credit spreads, prompting some FOMC members to worry about "potentially excessive risk-taking," according to the minutes of the December meeting.

More recently, there has been a "significant change in the risk appetite" among hedge funds -- illustrated by an "across-the-board selloff in carry trade instruments" such as corporate credit and emerging market bonds, says Mohamed El-Erian, managing director at Pimco. He also cited weakness in the Dow Jones CDX indexes -- baskets of credit default swaps on emerging-market or high-yield names favored by hedgies. (There has also been sharp weakness in several South and Central American bourses recently, while South Korea's KOSPI is looking technically shaky too, notes RealMoney.com contributor Helene Meisler.)

The selling "reached a crescendo" Wednesday with General Motors' ( GM) shocking profit warning, El-Erian continues, suggesting the automaker's bombshell "took the concerns about corporate bonds from a top-down technical sphere to a bottom-up credit sphere." ( RealMoney.com contributor Tony Crescenzi also examined this development.)

Whether that selloff resumes remains to be seen; but with the Fed in a determined tightening mode, the domestic economy growing and oil prices surging, U.S. yields are rising. That, in turn, "fundamentally undermines the carry trade," El-Erian continues, referring to the widespread practice by speculators of borrowing cheap dollars and reinvesting them at higher yields overseas.

The carry trade has been the fuel for "aggressive moves" in the past two-plus years for (among others) the Brazilian real, South African rand and Turkish new lira, according to Greenwald. With U.S. rates rising, "it's not quite as easy to short dollars and I think you can expect a lot of that money to flow back" into the U.S., he says. Notably, the rand has been weak for much of 2005 and the real has fallen sharply in the past month. The carry trade has also fueled speculation in commodities that would be hurt if the dollar rallies, as (most likely) would the red-hot stocks of commodity producers.

Finally, there's that biggest emerging market of all: China.

Two weeks ago brought news that oil shipments to China fell 13% in January-February, raising concerns about a possible "hard landing" in that country. This week brought the sudden resignation of the head of the China Construction Bank, the nation's second largest, reviving concerns about the stability of the financial sector. Even unabashed China bull Donald Straszheim, of Straszheim Global Advisors, admits "trouble persists at China's troubled big-four state-owned banks -- stay away."

Furthermore, if there was pervasive accounting fraud in the Fortune 100, why not in China's emerging quasi-capitalist economy?

The point being that if/when China allows its currency to float or (more likely) widens the trading band, it may ultimately result in weakness -- rather than strength -- in the renminbi against the greenback.

That's very much a contrarian viewpoint but, then again, that's the point of this exercise.

Aaron L. Task is the co-executive editor of TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to atask@thestreet.com.

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