U.S. dollar rallies as Europe, Asia fade

WASHINGTON Mon Aug 25, 2008 8:36am EDT

A money changer awaits clients at a market in Seoul July 11, 2008. REUTERS/Ben Weller

A money changer awaits clients at a market in Seoul July 11, 2008.

Credit: Reuters/Ben Weller

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WASHINGTON (Reuters) - The U.S. dollar is enjoying its strongest rally in three years largely because of bad news abroad rather than good news at home.

Just as the greenback's swift decline earlier in the year set off alarm bells with world policy-makers who worried that it was contributing to overheating inflation, a swift rise that hurts U.S. exports would not be welcome either.

Currencies are typically viewed as proxies for their underlying economies, and the dollar is no exception. What makes it somewhat unusual is that it is the dominant currency of global trade. Its movements are intricately linked to the price of oil, which in turn is vital to the world economy.

Economists widely think the second quarter was the high water mark for the U.S. economy this year, and a fourth-quarter contraction is not out of the question. If anything, the outlook has worsened in recent weeks as credit concerns spike and investors worry that the government may have to bail out mortgage finance giants Fannie Mae and Freddie Mac.

So why has the dollar climbed 7 percent against a basket of currencies since July 15? It's all relative. The U.S. economic outlook may be grim, but that of the rest of the developed world is rapidly deteriorating.

"This spreading weakness abroad -- and it is worse now in Europe and Japan than it is in the USA -- is the primary reason for the dollar's recovery," Merrill Lynch economist David Rosenberg said.

Data released on Friday showed that Britain's economy generated zero growth in the second quarter. The euro zone recorded its first ever contraction during that period.

Revised figures due on Thursday are expected to show the U.S. economy grew at a solid 2.7 percent annual rate in the second quarter, according to economists polled by Reuters, well ahead of the 1.9 percent pace that was initially reported.

But don't expect much of a celebration on Wall Street because few believe this pace can be sustained. Ironically, the recent resurgence in the dollar is part of the reason why.

TRADE CHANNELS

For the global economy, a strengthening dollar is a mixed blessing. It is good news for European exporters, who have long complained that a pricey euro was hurting their business. It is not such great news for the U.S. economy, which has relied on healthy export demand to compensate for sluggish domestic consumer and corporate spending.

Indeed, foreign trade added 2.4 percentage points to second-quarter real U.S. GDP, its largest contribution in nearly 28 years, according to calculations from research firm Global Insight. Thursday's data revisions may show that it provided an even stronger 3.2 percent kick. In other words, without trade, the second-quarter GDP figure could very well have been negative.

In a speech on Friday, U.S. Federal Reserve Chairman Ben Bernanke called the dollar's stabilization and the recent cool-down in the oil market "encouraging."

But currencies, like economies, can rise too quickly for comfort, and in ways that are not healthy.

To the extent that the strengthening dollar has helped to lower oil prices, it is clearly a positive for the global economy. Oil is down more than $30 per barrel from a July peak just above $147. But if the currency's strength simply reflects weakening in Europe and Asia rather than an improvement at home, that does not bode well for the U.S. or world economy.

Even if the currency moves make Europe's exports more competitive, that doesn't mean much if a weak global economy saps demand. If U.S. exports falter, there is not much left to prop up the world's biggest economy.

Global Insight thinks it will be 2010 before the world economy rebounds.

"World economic growth in 2009 is likely to be the slowest since 2003," chief economist Nariman Behravesh said. "Every world region's growth is expected to slow next year, and the list of countries in or near recession is expanding."

Edward Leamer, director of the UCLA Anderson Forecast, said U.S. economic data still suggest a weakening economy rather than a full-blown recession, but the stronger dollar poses a significant threat to that outlook.

"If this is a symptom of potentially weaker exports going forward, then we're in another high-risk period," he said.

(Editing by Dan Grebler)

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