Economists, who now see American troubles spreading around the world are predicting that foreign central banks will ignore the gathering inflation threat and follow the U.S. Federal Reserve down the rate-cutting path. Similarly, they argue that since the downturn began here, the recovery of the U.S. economy will likely be under way while the rest of world is still decelerating. 

These assumptions have prompted a recent rally in the U.S. dollar, and an accompanying sell-off in gold, commodities and foreign stocks, and have cast doubts on the ability of foreign economies to economically "decouple" from the United States.

But investors should not take the bait.

America and the U.S. economy does, indeed, pose a global threat, but not for the reasons these economists suppose.  Foreign economies are suffering not because American consumers have slowed their voracious spending, but because they are defaulting on hundreds of billions of dollars of existing loans underwritten by lenders around the world.

The conventional wisdom is that foreign economies depend on American consumers to buy their exports.  This is false.  The global expansion of the past decade has created new demand everywhere, and people and businesses in all corners of the world are spending.  Indeed, in markets such as China, the government is actually taking steps to stoke domestic demand.

In America, however, spending has largely been achieved through a massive vendor-financing scheme.  Foreign-supplied credit has allowed American consumers to continue buying, even while American income and savings have dropped.  As this credit goes bad, the losses are landing on the bottom lines of foreign financial firms. 

In other words, the global pain is not resulting from a contraction in the U.S. economy, but from having financed our preceding expansion.  This is a critical distinction few have been able to make, and it is vital to appreciating the economic decoupling that already has occurred beneath the surface.

The current losses that banks in Europe and Asia are now suffering are real, but future losses can be avoided by suspending lending to Americans.  Shutting off this credit will torpedo the dollar, but that is precisely what must occur.  By allowing the U.S. dollar to drop to its natural, unsupported level, not only will the American caboose be decoupled from the global gravy train, but it also will allow the rest of the cars to move along the tracks much faster.  Outside the United States, there still will be plenty of consumers to buy what is produced, and plenty of investment opportunities for those with savings.  Rather than dragging the global economy down, such a development would actually un-tether it.

On the other hand, left to its own devices, the U.S. economy will implode.  There will be fewer products for American consumers to buy and very little savings for anyone to borrow. 

Some foolishly believe that many of the world’s problems result from the U.S. dollar weakness, and that pushing the American greenback back up would be good for all.  For example, the thinking goes, since the weak dollar contributed to the escalation in oil prices, the strengthening dollar should help bring prices down.  

However, if foreign governments weaken their own currencies to push the dollar up, they will simply succeed in bringing oil prices down for Americans.  Oil prices will go up for their own citizens.  This can’t be an attractive bargain for any European or Asian political leader.

The weak dollar is merely a manifestation of substantial structural problems underlying the American economy.  Unfortunately for us, the solution to those problems, as well as the global economic imbalances, can only be found in a weaker dollar.  Efforts to artificially prop up the U.S. dollar will only exacerbate those imbalances, and make its ultimate fall that much more severe.

[Editor's Note: Peter D. Schiff, Euro Pacific Capital Inc.'s president and chief global strategist, is a regular contributor to Money Morning, and most recently wrote about the gloomy "financial reality" that's facing U.S. consumers and feeding directly into the looming "Super Crash." Get our report on the once-in-a-lifetime profit plays that will emanate from this Super Crash - and get a free copy of Schiff's New York Times bestseller "Crash Proof: How to Profit from the Coming Economic Collapse" -please click here.]

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• Merrill Lynch Press Release:
  Global Economic Decoupling Gathers Pace – but It’s a Marathon, Not a Sprint, Says Merrill Lynch.

• Wikipedia:
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• Money Morning Exclusive Interview:
  Exclusive Interview: Jim Rogers Predicts Bigger Financial Shocks Loom, Fueling a Malaise That May Last for Years.

• Money Morning Economic Analysis:
  China Plans $58 Billion Stimulus Package and Rate Cuts as Policy Shifts from Inflation to Growth. 

The U.S. greenback surged Friday, capping off the biggest weekly dollar rally in three and a half years, as the euro slumped on speculation the European economy would continue to weaken.

The euro fell as low as $1.5008 Friday afternoon, dropping more than 2% from $1.5325 Thursday – the biggest one-day drop since Sept. 6, 2000.  Against the yen, the European currency traded at 165.84, from 167.70. In the dollar rally, the euro has declined 3.1% against the greenback in its fourth weekly decline.

In addition to rising against the euro, the greenback climbed 0.5% to 109.97 yen after touching 110.08, the strongest since Jan. 10, Bloomberg News reported. The U.S. currency advanced 2.1% in its biggest weekly gain since June.

"This is the beginning of a new chapter for the dollar as [ECB President Jean-Claude Trichet] and other central banks are paying more attention to the downside risk to growth," said Dustin Reid, a senior currency strategist at ABN Amro Holding NV (OTC ADR: ABNYY), told Bloomberg. "The decline of oil prices is a significant driver behind this dollar rally because it enables other central banks to turn their eyes away from inflation and focus on growth."

Trichet said Thursday that while growth would be "particularly weak" in the second and third quarters, inflation is "likely to remain well above levels consistent with price stability for a protracted period of time."

European retail sales dropped by the largest margin in at least 13 years in June, sliding 0.6%.  Business and consumer confidence plunged in the 15 countries using the euro in July, as the EU’s economic sentiment indicator fell to 89.5 – the lowest level since March 2003 and the sharpest month-to-month drop since October 2001.

Italy’s economy unexpectedly shrank in the second quarter, coming closer to its fourth recession in a decade. The economy, contracted 0.3% after expanding 0.5% in January to March.

It’s likely that Germany’s economy is shrinking as well. Germany’s factory orders for June fell 2.9% in June, after a 1.4% decline in May, leading economists to speculate that economic growth in Europe’s largest economy is contracting.

The German economy contracted by 1% in the second quarter, and Eurozone growth may was flat at best, economists at BNP Paribas SA (OTC: BNPQY) said in a research note.

Dire growth prospects outside the United States have also lead to a steep drop in commodities prices. Oil plunged $4.82, or 4%, settling at 115.20. Oil has now plummeted more than 20% from its July 11 record of 147.27. Gold fell $15.50, or 1.77%, Friday to $862.40 an ounce. The prices of other metals and crops sank as well.

"The dollar is, in my view, in a genuine recovery," Stephen Jen, global head of currency strategy at Morgan Stanley (MS) in London, told Reuters. "This trend could run further than many think," said.

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• Reuters:
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It’s unfortunate that the U.S. Supreme Court, in its ruling last week that U.S. currency is unfair to the blind, did not make the next logical step and declare it unfair to everyone who buys gasoline.

In their search for explanations as to why oil has surged past $130 per barrel, Washington, Wall Street and the financial media are as clueless as cavemen after a freak summer snowstorm. Despite the head scratching, the blame game is nevertheless in full force. 

Speculators and big oil companies are being trotted out as scapegoats, and increased margin requirements and taxes on windfall profits and futures trading have been mentioned as appropriate sanctions. It should be clear that this is pure farce, and that no one understands what is actually happening.

The reality is that after years of reckless consumption and dollar debasement, Americans are now being priced out of the very markets over which they formerly held unchallenged title. As more affluent foreigners consume more of the resources and products they previously exported to us, Americans are being forced to cut back. The rising dollar-based price of gasoline is simply an illustration of this global trend.

Poorly concealed behind contrived government statistics, the signs of America’s falling standard of living are everywhere; all one has to do is look. We are unloading our SUVs for less-desirable compacts, and are paying more to fly on crowded planes (where we pay to check luggage and dine only on what we bring onboard). We now buy our lattes from McDonald’s Corp. (MCD) or not at all, and we increasingly forego dining out, trips to the mall and vacations – just so we can scrape together enough to fill our gas tanks and kitchen pantries, pay taxes and insurance, or make credit card, mortgage or car payments.

The collective belt tightening is simply the down payment on the U.S. government’s massive bailout of Wall Street investment banks and mortgage lenders. As the U.S. Federal Reserve creates money to buy bad mortgages and other shaky securities held by banks and brokerage firms, the value of the savings and wages of everyone on Main Street will continue to fall. As a result, the costs of products previously taken for granted have begun to bite. 

The various housing bills and stimulus packages now passing through Congress will add significantly to the staggering final price tag. In the end, the "free lunch" currently being dished out by Washington will be the most expensive meal ever served. The cost will be borne by ordinary Americans citizens every time they open their wallets. And four-dollar gasoline is just the beginning.

For all the talk of increased global demand, few seem to understand from where it actually comes. The surge in global demand is both a function of the increased purchasing power of foreign currencies and the fact that foreigners are choosing to spend more of their incomes themselves.

In other words, former Fed Chairman Alan Greenspan’s famous "global savings glut" is turning into a global consumption binge, with Americans unable to crash the party. This trend will only get worse as the dollar-denominated price of just about everything that is either imported, or capable of being exported, goes through the roof. 

We can look for scapegoats all we want but the simple fact is Americans are going to have to get used to a much lower standard of living. Those who have been putting all the food on our tables are finally pulling up chairs and are serving themselves.

[Editor's Note: For a more-detailed analysis of the nation's financial problems, and the inherent dangers that these problems pose for both the U.S. economy and for dollar-denominated investments, click here to download Schiff's new financial-research report, "The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities." The report is free of charge. Schiff wrote about China's growing consumer class in his most recent Money Morning column.]

News and Related Story Notes:

• Euro Pacific Capital Inc. Special Research Report:
  The Collapsing Dollar: The Powerful Case for Investing in Foreign Securities.

• Money Morning Financial Analysis Report:
  As China’s Consumers Start Spending More, U.S Consumers Will Begin to Feel the Global Economic Squeeze.

• Money Morning Commodities Investing Series:
  Cashing in on Commodities: What’s Driving the Oil Bull, How Much Further It Will Go, and How Investors Can Profit.

• Money Morning Financial Commentary:
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• Money Morning Weekly Outlook Report:
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• Money Morning Financial Commentary:
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• Money Morning Special Investment Report:
  Money Morning Boosts Oil Target Price to $225 a Barrel, Thanks to Continued Scarcity, Burgeoning Demand in China.

• Wikipedia:
  Farce.

The dollar continued its rise today (Monday) on the assumption that the U.S. Federal Reserve plans to halt its aggressive rate-slashing campaign.

Federal Reserve Chairman Ben S. Bernanke will be speaking tomorrow (Tuesday) and is expected to confirm that the Fed plans to hold rates steady at the next Federal Open Market Committee (FOMC) meeting on June 24 and 25.

"Much of the recent dollar appreciation is on the back of speculation that the country’s economy may have turned something of a corner so anything that serves to derail this observation will ultimately end up weighing on the greenback," James Hughes, a market analyst at CMC Markets PLC, told The Associated Press. "The assumption, however, remains for the time being that the Fed is nearly at the end of its accommodative approach to monetary policy and the run of cuts we’ve seen of late will not continue for much longer."

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After reaching a historic low of $1.6019 versus the euro on April 22, the dollar has since gained 3.5%. Language in the April 30 FOMC statement that the "substantial easing of monetary policy to date" would help "promote moderate growth over time" was a signal that the Fed is ready to ease off and let the Fed Funds rate stay at its current level of 2.0% over the coming months.

"It’s not going to be an express train toward a much stronger dollar, but it will trade stronger slowly and gradually," Jeff Gladstein, global head of foreign-exchange trading at AIG Financial Products (AIG) in Wilton, Connecticut, told Bloomberg News. "The [United States] is not going to have as deep a downturn as everyone initially portrayed."

Bloomberg reports that traders are finally taking a bullish stance on the dollar for the first time in over two years. And Fed Funds futures traded on the Chicago Board of Trade are indicating an 82% probability that the FOMC will vote to hold rates steady in June.

If the Fed pauses as is expected, it should help to bolster the weak greenback.

"It’s doubtful that the Fed can afford to cut more," Benedikt Germanier, an analyst at UBS AG (UBS) in Stamford, Connecticut, in an interview on Bloomberg Television. "We are short on the euro-dollar. Our three-month forecast is $1.47."

At 11:01 in New York, the dollar traded at $1.5496 against the euro according to Bloomberg.

News and Related Story Links:

• CNNMoney.com:
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• Bloomberg News:
  Dollar Climbs on Speculation Fed to Halt Cuts, Losses Overdone

Don’t mistake the U.S. dollar’s recent rally for strength. If anything, it’s a head fake of legendary proportions.

In fact, the dollar’s recent run-up is actually a warning that risks are escalating.

To better understand what I mean here, let’s look at the greenback’s recent performance against the euro. After bottoming at an all-time low of $1.6019 versus the euro on April 22, the dollar has soared nearly 4% and was trading at $1.5428 per euro early yesterday (Wednesday).

Now many of the Wall Street types expect that rally to continue. Just yesterday, UBS AG (UBS) predicted the greenback would rise to  $1.47 in three months. That would be a jump of 5.0% from where the dollar is trading now, and would represent a total rebound of about 8.0%.

I mention this forecast because UBS is the world’s second-biggest currency trader, meaning the Swiss banking giant’s projection is certain to get lots of play.

Here’s my advice on this forecast: Ignore it.

Out of Touch With Reality

The so-called "dollar rally" is illogical, irrational and is unfolding at precisely the wrong moment – which means that many investors who are long on the dollar could get a nasty surprise if they don’t temper their enthusiasm a bit in the months to come.

Granted, there are a lot of things that happen at the wrong time when it comes to the financial markets. But the prospect of watching the dollar rise at the same time that oil and gold are advancing (a scenario that we don’t have right now, given gold’s retreat, but one that I won’t be surprised to see, given current conditions) is downright disconcerting – if for no other reason than the history books show a pronounced negative correlation over time between these assets.

Couple that concern with the reality that the Bush Administration’s policy for the dollar has been one of benign neglect and you can come to only one conclusion: Absent an increase in interest rates by the U.S. Federal Reserve, any increase in the value of the dollar must be viewed as an anomaly.

And anomalies merit scrutiny.

One possible set of answers comes from an unusual source – the London Interbank Offer Rate (LIBOR) system of setting interest rates.

The LIBOR Lambada: The "Forbidden Dance."

LIBOR, in case you’re not familiar with it, is the rate banks charge each other to lend money. It’s the net result of data on loan duration calculations ranging from overnight funds to as much as a year in 10 different currencies submitted by 16 major international banks and published each morning by Reuters.

Even though most investors focus on the U.S. Federal Funds rate, which is the benchmark for such key U.S. financial measures as the Prime Rate, LIBOR drives global calculations involving trillions of dollars of corporate debt, mortgages, financial derivatives and other financial instruments. And that makes LIBOR one of the single-most-important daily interest-rate calculations in the global financial markets. And it may actually be the most important benchmark.

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And that brings us back to what’s happening with the dollar.

Because LIBOR represents the rates banks charge each other as part of the lending process, and because interest rates are an assessment of risk, rising LIBOR rates could be interpreted as an indicator of escalating risk, particularly if rates associated with it increase at a time when central banks the world over seem to be completely committed to lowering rates.

This is immensely troubling, because it appears as if the dollar rally is nothing more than the powerful head fake I mentioned a moment ago.

You see, when banks submit their LIBOR rate-related data, they’re supposed to submit their true borrowing costs honestly and without bias. The entire LIBOR-submission system works on the honor system – meaning there’s no regulatory agency reviewing the information to ensure its accuracy and truthfulness.

Yet, the rates that come from that data serve as the basis for worldwide valuations.

If that doesn’t sound familiar, it should. The same "Old Boys Club" responsible for the global credit crisis is responsible for self-policing its LIBOR data submissions. And we all know where that led when the "true" costs of the credit crisis and the off-balance-sheet transactions began to surface last summer.

And it wasn’t pretty.

In very real terms, no bank wants to submit data that reveals it is having trouble borrowing money or making loans. Not only would such data invite more scrutiny, but it also would potentially raise new valuation questions related to liquidity, bad-loan levels and the remaining levels of off-balance-sheet derivatives exposure at a time when the financial sector least needs it and doesn’t want it.

The upshot: As Money Morning reported to you several weeks ago, there’s no incentive for any member in the LIBOR-submission group to submit data that, while accurate, reveals its weakened state. That means that rising LIBOR rates – instead of signaling a newfound strength in the greenback – are actually demonstrating that the banks don’t trust one another, and are charging a premium for their money in a global-markets game of blind man’s bluff.

Think of it this way. It could well be that the same coterie of global bankers who brought us the global credit crunch could collectively now be manipulating LIBOR – and by extension – the U.S. dollar.

With this crew at the controls, it means that the dollar is gaining altitude, and not because it’s worth more, or because the outlook for the U.S. economy is more upbeat. The dollar is rallying on nothing but increased risk.

Two pieces of evidence back up my theory.

First, the British Banker’s Association has already launched an investigation into some of these LIBOR-related machinations. And when the BBA then announced that it was accelerating its probe, former professional bond trader and private investor R. Shah Gilani pointed out that "LIBOR jumped."

And so did the dollar.

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• Bloomberg News:
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• Money Morning Financial Commentary:
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• British Banker’s Association:
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Oil sailed to a fresh record Tuesday as the dollar’s continued weakness made an already fashionable retreat into oil all the more appealing.

The price of light, sweet crude for May delivery settled at a record $113.79 a barrel after touching a new trading high of $113.99 a barrel in early morning electronic trading on the New York Mercantile Exchange.

"Traders on the Nymex saw the dollar take another tumble, so they did what they have been conditioned to do when the dollar falls, i.e. they bought crude oil," Stephen Schork wrote in his popular industry newsletter, the Schork Report.

The dollar hit its latest all-time high against the euro last Thursday, hitting $1.5832. Monday, Wachovia Corp. (WB), the fourth-largest U.S. bank, announced a surprise first-quarter loss. The company also slashed its dividend and revealed plans to raise $7 billion in capital. As a result investors have lost even more confidence in the financial sector, and by extension, the U.S. dollar.

"This news highlights the strains in the banking sector and credit markets and that has led to more dollar selling, and so that tends to drive investors into oil and other commodities," Viktor Shum, an analyst with Purvin & Gertz, told the Associated Press.

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Oil’s price jump was also bolstered by the Organization of Petroleum Exporting Countries’ decision to hold production steady and maintain its 2008 estimate for growth in world oil demand.

"The fundamental picture in the second quarter of 2008 appears to be in line with the typical seasonal pattern for this time of year," the group said in its April report. "Current OPEC production at more than 32 million barrels per day will be sufficient to both meet demand growth and contribute to further stockbuilds."

Despite strong demand from China and India and record high oil and gas prices, the members of OPEC, who control 40% of the world’s oil supply, believe demand is still very much at risk.

"With growing concerns about the slowing U.S. economy and higher gasoline prices, there is a chance that the decline could be more pronounced, leading to even lower demand in the second quarter," the report noted.

U.S. inventories unexpectedly dropped in the week ended April 4, and Wednesday’s report for last week is expected to show further declines.

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The dollar rose the most against the euro this year yesterday (Tuesday), an indication that it could be readying itself for a rebound.

"The market focus has shifted," Michael Malpede, a senior currency analyst at Man Global Research, told Bloomberg. "We are going to see the dollar bounce further.

So far this year the dollar has been bullied by foreign currencies. It suffered its biggest quarterly drop against the euro in nearly four years in the first three months of 2008, falling 8.2%. However, the gasping greenback showed signs of life yesterday, climbing more than 1.3% against the euro in early morning trading.

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The dollar also gained against the Swiss franc (up 1.4%) and Japanese yen (up 2.15%). The dollar index, which measures the greenback against a basket of currencies, was at 72.522, up from 71.749 late Monday. It had dropped to a record low of 70.698 on March 17.

The rally was, in part, spurred by strong data from the Institute of Supply Management, whose index increased from 48.3 in February to 48.6 in March.

It was also bolstered by a recovery in the financial sector, which climbed 5% on news that Lehman Bros. Holdings Inc. (LEH) and UBS AG (UBS) would raise $19 billion. Lehman sold $4 billion in shares and UBS said it would seek $15 billion in a rights offering.

The dollar’s spike means trouble for commodities prices, which benefited greatly from a floundering financial sector and weak dollar.

"Everything from cotton to copper and soybeans to silver is off sharply," Jon Nadler, senior analyst at Kitco Bullion Dealers, told MarketWatch. "The ever-weakening dollar had prompted many a fund to pile money into the sector since September last year, pushing values of some commodities well beyond fundamentals."

"But now, as the dollar is staging somewhat of a comeback, even if a temporary one, the niche is being drained of money quite fast," Nadler said.

Gold for June delivery tumbled $33.70, or 3.6%, to close at $887.80 an ounce on the New York Mercantile Exchange, as investors abandoned their hedge positions. The precious metal earlier fell to a low of $876.30.

May silver futures fell 42 cents to $16.89 an ounce, June palladium fell $1.60 $448.60 an ounce, and May copper futures dropped 2.1 cents, to $3.81 a pound. Oil dropped 60 cents, or 0.6%.

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When some commentators see how steadily the U.S. dollar has declined against a basket of key world currencies, they’ve labeled it the "death spiral" of the greenback.

They couldn’t be more wrong.

To the U.S. economy and to investors in U.S. companies, the dollar’s current spiral is much closer to a strand of DNA – the spiral of life.

Let me explain.

Federal Reserve Chairman Ben S. Bernanke and the U.S. central bank have aggressively cut interest rates, sending them down below the rates of other major global economies and below the rate of U.S. inflation. As long as interest rates remain below those two levels, a number of things will happen:

• Commodity and energy prices will keep rising, towards the $187 oil that my colleague, Money Morning Investment Director Keith Fitz-Gerald has forecast. Consumer price inflation will keep on creeping upward, as prices for goods from China and other source countries go through the roof.
• And the dollar will continue to decline against other major currencies, causing much wailing and gnashing of teeth amongst those who take a more macho view of their currency’s strength. 

There are three possible alternatives the Fed and the U.S. Treasury might take in response to the dollar’s decline:

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1. Raise Interest Rates: In the long run, raising rates will be necessary to get control of inflation. But the longer the Fed can delay ratcheting up the Federal Funds rate, the more likely it is that house prices will first have time to bottom out, restoring confidence to mortgage holders and the debt market. Raising rates sharply would immediately boost the value of the greenback, but may well cause a sharp economic slowdown. It would be much better if we could avoid that slowdown coinciding with the current meltdown in the bond markets, so it’s best to hold off on this idea for now.
2. Intervention: A second option would be to "intervene" in the foreign exchange markets to increase the value of the dollar against other currencies. This could be done without raising the Fed Funds rate and, ideally, the Fed would not be acting alone in this intervention. Other central banks, most notably those in Europe and Japan, would also want to push up the dollar in order to improve margins for their own suffering exporters. There are reports that central banks around the world could be part of a joint-intervention effort.

   But with U.S. interest rates as low as they are currently, intervention would probably be frighteningly expensive. It would mean the U.S. government would essentially be handing free money out to the pretty unsavory tribe of international currency speculators, because with interest rates at current levels, there is no economic reason to buy dollars.

   The U.S. balance of payments is still close to $700 billion in the red, so money naturally flows out of the United States unless foreign investors can be persuaded to buy. Treasury yields are lousy, and foreign investors can generally [except for the Japanese] get a higher interest rate in their own currencies. The U.S. stock market is dropping, and prospects for improved U.S. earnings look, at best, unexciting. Real estate prices and occupancy rates are currently weakening.

   Given all these economic reasons for the dollar to slide, a U.S. government that intervened against it might find itself in the position of the Anglo-Danish King Knut, who placed his throne on the beach and commanded the tide not to come in. Not a good idea!

3. Do Nothing: The third possible response to a weak dollar is to simply do nothing [all the while possibly maintaining the polite fiction of both President George W. Bush and Treasury Secretary Henry Paulson that the objective is a strong dollar - if they can avoid breaking out in giggles!]. Doing nothing means the greenback would probably continue its gentle decline against other currencies. And for wealthy travelers to Europe, that might be a disaster. For consumers at home, it would tend to increase inflation, but inflation is rising anyway. I doubt a strong dollar could stop it. Exporters would benefit the most, as they find themselves increasingly competitive, and perhaps able to reestablish themselves in markets they had abandoned to European or Asian competitors a decade ago.

   Since the U.S. economy is decidedly weak at the moment, a competitive advantage abroad would in turn be enormously helpful to employment in manufacturing and exportable service industries and by extension to the profits of U.S. companies with large international businesses.

   At the top end, it could even cushion the housing-market downturn, as wealthy European and Asian investors would find bargains in fashionable markets such as California, Nevada and Florida where overbuilding had been most rampant. The trade deficit would continue to decline, making the dollar sounder and reducing the need to attract scarce foreign investors.

   There are few factors more beneficial than a weak dollar in restoring the U.S. economy to full strength. Far from representing an economic "death spiral," a weak greenback represents the DNA spiral that can give the economy new life, especially in exporting sectors. Ideally, the U.S. balance of payments deficit could be sharply reduced and the housing market stabilized before interest rates have to be raised to fight inflation. When rates are raised – and they will be – the dollar will inevitably strengthen. At that point it might indeed make sense to "intervene" against its newfound strength and cushion any domestic recession.

To play this scenario, I would make three recommendations:

• First, to guard against rising inflation, consider the StreetTracks Gold ETF (GLD). This ETF offers bullion-based pricing without the storage problems and liability of delivery.
• Second, to profit from the likely rise in Treasury bond yields and decline in prices as inflation takes hold, look at the Rydex Juno Inverse Government Long Bond Strategy C Fund (RYJCX), which is designed to move inversely to Treasury bonds. The fund shorts futures contracts on long-term Treasury bonds, so it benefits when rates rise.
• Third, to profit directly from the decline in the dollar and the subsequent rise in U.S. exports, consider investing in an American company with strong global sales. The Boeing Co. (BA) is America’s biggest exporter, by far. And while it’s true the company has hit a bit of a rough patch of late with both its new Dreamliner 787 jetliner and an Air Force tanker contract, don’t make the mistake of counting this company out – it is poised to be a big beneficiary from the expansion of the Asian economy, where China alone will need $340 billion worth of aircraft over the next two decades. Also take a look at Nucor Corp. (NUE), the semiconductor manufacturing giant Intel Corp. (INTC), or forest products giant International Paper Co. (IP) which could provide alternatives. 

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The dollar made a small rally last week, taking much of the upward pressure off commodities. But that rally may be short-lived, as many analysts expect the dollar to continue its downward decline after its brief rally.

The dollar traded as high as $1.511 per euro Thursday, which put it within in striking distance of its first weekly gain against the euro in more than a month. The dollar gave back some of those gains on Friday, sinking to a value of $1.544 per euro in early trading. The dollar bought 99.39 yen on Friday, up 0.4% for the week.

"The dollar is enjoying a bounce," Hideki Amikura, deputy general manager of currencies at Nomura Trust and Banking Co. (NM), told Bloomberg News. "The Fed is working to restore credit confidence. U.S. investment bank earnings weren’t as dire as some predicted."

Commodities reflected the dollar’s gains last week by posting significant losses. Gold, which last Monday hit a record high of $1,034 an ounce, traded as low as $919.20 an ounce Friday, a 11.1% drop. Oil, which also traded at a record high last Monday, trading at $111.80 a barrel, fell below the $100 mark Thursday for the first time in two weeks.

However, the sharp drop in commodities wasn’t solely attributable to the rise of the dollar. Position unwinding and profit taking exaggerated the price drops, as underlying fundamentals do not support record high commodities prices. 

Last week, when the U.S. Department of Energy said that the demand for oil was beginning to wane amid a global economic downturn, commodities traders were forced to recognize that commodities are not immune from the downward pressure of an economic slowdown. The Energy Information Administration’s weekly inventory report said Wednesday that overall consumption of oil and its products fell 3.2% over the last four weeks compared with the same period last year.

Meanwhile, most analysts believe that, despite recent gains, the dollar still has further to drop, especially in light of the U.S. Federal Reserve’s massive injections of liquidity.

In one of the most aggressive rate-cutting campaigns in a generation, the policymaking Federal Open Market Committee (FOMC) has cut the benchmark Federal Funds rate six times in the past seven months taking it from 5.25% to 2.25%. The most recent reduction came last week, when central bank policymakers pared the benchmark short-term rate by three quarters of a percentage point.

Money Morning Investment Director Keith Fitz-Gerald believes that Fed Chairman Ben S. Bernanke is selling the dollar down the river.

"The government has adopted a weak-dollar policy," Fitz-Gerald said. "They’re sending out a message loud and clear: ‘We want you to sell the dollar.’"

The dollar may be granted a temporary reprieve from speculative investors looking to cash in on a currency they view as being oversold. But a sustained dollar rebound may not be in the making for quite some time. 

"Until global traders decide the dollar has had enough, I don’t expect a rebound," Fitz-Gerald said. "Not while Bernanke is busy debasing our currency."

As far as commodities go, Fitz-Gerald thinks the long-term outlook remains bullish and any pullback represents another opportunity to buy in.

"I’m a long-term commodity bull no question about it," he said.  "Commodities may drop further, but that will be a function of fear about slowing economies, not a lack of demand."

News and Related Story Links:

• International Herald Tribune:
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• Bloomberg:
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• Money Morning:
  Is the Fed Fueling the Inflation Fire?

• Money Morning News Analysis:
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• Money Morning News Analysis:
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Commodities, which have been some of the most profitable investments of the past 18 months, tumbled yesterday (Thursday). Oil and gold were just a few of the raw materials whose prices plummeted on speculation that demand will slacken and the dollar will rebound in coming months.

Crude oil fell below $100 a barrel for the first time in two weeks yesterday, extending heavy losses sustained in the previous session. Oil hit a record high $111.80 a barrel Monday, but dropped nearly $5 on Wednesday.

A report from the energy department, which indicated demand for oil may be waning amid a global economic downturn, was at least partly responsible for the decline. The Energy Information Administration’s weekly inventory report said Wednesday that overall consumption of oil and its products fell 3.2% over the last four weeks compared with the same period last year.

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Also, many speculative investors seem to be liquidating their assests and taking profits, as fundamentals do not support record high commodities prices.

"Commodity players seem to be coming round to the notion that the deterioration in the U.S. macro picture cannot be ignored on the pretext that commodities are a ‘weak dollar play’ or an ‘inflation hedge,’ and thus immune from downward pressure," MF Global Ltd. (MF) analyst Edward Meir, said in a research note.

The sudden epiphany that many commodities are overvalued also sent gold into a tailspin. After hitting a record high of  $1,034 an ounce just four days ago, gold plummeted 12% in its biggest weekly decline in 25 years.

As is the case with oil and other commodities, investors seem to be waking up from the misconception that the price of gold will rise every time the economy, or the dollar, weakens.

Dollar Bounces Back

A resurgent greenback also weighed heavily on commodities prices. The dollar staged an impressive rally Thursday, though most analysts believe it only to be temporary. After hitting a series of record lows against the euro the dollar advanced to $1.5411 per euro.

"It looked like the sky would fall, which is why we got up to those record levels Monday," Jon Nadler, senior analyst at Kitco Bullion Dealers in Montreal, told CNN. "But when the dollar started a bit of a gain [yesterday], people pulled the trigger across the commodity board."

While the dollar came off its historic lows yesterday, few analysts believe the latest upward trend is the beginning of serious recovery. More likely is the possibility that currency traders priced in a larger cut from the U.S. Federal Reserve. The Fed slashed the benchmark Federal Funds rate by 0.75% Tuesday, but many analysts had anticipated a full-point reduction.

"The smaller-than-expected Fed Funds rate cut and the emphasis on inflation risk in the Federal Open Market Committee statement have effected a reassessment of the further outlook for U.S. monetary policy," said analysts Dresdner Kleinwort, the corporate and investment banking unit of Germany’s Dresdner Bank AG. "As the market regards the potential for another rate cut as small, gold and other metals are under pressure."

Many analysts believe after a mild recovery, the dollar will continue its downward descent, perhaps falling as low as $1.60 per euro.

"I would see this as a temporary [move] since we expect that the Fed will go on cutting. I don’t think we’ve seen the lows for the dollar and I don’t think we’ve seen the low for stock markets. It’s unlikely that this will be the bottoming out for risk aversion," Johan Javeus, FX strategist at SEB in Stockholm, told Reuters

News and Related Story Links:

• MarketWatch:
  Gold continues slide as dollar rallies

• Wall Street Journal:
  Dollar Continues to Strengthen As Commodity Prices Tumble

• BusinessWeek:
  Oil falls under $100 on waning demand

• Bloomberg:
  Gold Leads Commodities Plunge on Outlook for Dollar, Economy

• Money Morning:
  Dollar in Dumps, Sends Commodities Soaring Higher