There Goes the Euro… Again: Why the U.S. Dollar is Set to Rebound Against Europe’s Single Currency

by Alexander Green, Investment U’s Chief Investment Strategist

Thursday, November 18, 2010: Issue #1391

Eleven months ago, I began forecasting that the U.S. dollar would rise sharply against the euro.

Like most contrarian plays, it was widely mocked at the time. But it turned out to be a pretty good call until the middle of the year. That’s when the dollar started wilting again.

Today, however, the greenback is oversold once more and due for a bounce back. Here’s a quick rundown of what’s happening, why it’s happening – and what you should do about it…

Europe’s Turbulent 2010

I made my bullish case for the dollar near the end of 2009 for two primary reasons…

  1. The problems with the U.S. economy and national debt burden were widely recognized and fully priced into the currency.
  2. The problems in Europe were even worse. Debt as a percentage of GDP was just as high or higher in most countries across the pond. And nasty developments in the weaker member states were creating a problem for stronger ones.

As the financial crisis in Greece grabbed headlines earlier this year and began to weigh on the euro, the dollar rallied sharply against it in the first half.

But a bailout from fellow European nations and the International Monetary Fund shored things up – at least temporarily – and caused currency traders to begin focusing again on the large and growing U.S. budget and trade deficits.

That – plus the Fed’s announcement of “QE2″ (its latest round of quantitative easing) – has put the greenback on the defensive once more.

The Fed Keeps Pumping, While the European Dominoes Keep Falling

But two recent events indicate the dollar is set to resume its rise

  1. While the Fed is injecting $600 billion into the bond market to keep rates low, fixed-income investors are taking things into their own hands. The market is afraid that the Fed might be losing its grip on future inflation and fixed-income investors are voting with their feet, undoing Bernanke’s plans by selling off bonds and driving long-term rates higher. In turn, this is making the dollar more attractive to international currency investors.
  2. There are fears that Ireland will default on its debt. This would be a much bigger blow to the euro than problems in Greece because major European banks hold more of Ireland’s debt. And there are fears that if Ireland needs a bailout, so will Spain. Spain is a potential precursor to Portugal. And Italy isn’t far behind either. Can you spell d-o-m-i-n-o-e-s?

“It’s been simmering for a while,” Scott Brown, chief economist of Raymond James & Associates, said this week of the European debt problems. “Now it’s coming to a complete boil.”

What to do?

Is Your Portfolio Ready for the Euro’s Next Tumble?

Don’t sell your foreign-currency denominated stocks, as share price appreciation can easily outstrip the negative effects of a weak currency.

But for investors keeping score in greenbacks, this is not a good time to have large holdings in euro-denominated bonds or bank accounts. These investments are likely to post negative total returns if the euro sinks to fresh lows against the dollar… as I believe it will in the months ahead.

The rap against the euro when it made its debut in December 1995 was that the member states had such disparate economies that they would find it impossible to march to the same fiscal and monetary policies.

For a while, it looked like the eurozone might pull it off. But today, the luster is gone. The euro could easily fall 15% or more against the dollar over the next six to 12 months.

Govern your portfolio accordingly.

Good investing,

Alexander Green