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The Dollar Powers Through the Turmoil

DECEMBER 6, 2008, 11:58 P.M. ET
The Dollar Powers Through the Turmoil

By JOANNA SLATER
Amid the worst financial crisis in decades, the U.S. dollar has come roaring back to life.
Over the past four months, as investors around the world fled from risk, the dollar recouped more than two years' worth of losses against a broad group of currencies, including its swoon in the early part of this year.

Since the start of August, the dollar has strengthened 23% against the euro, 34% against the British pound, and still more against some currencies in developing countries.
Of course, the buck's recent rally hasn't fully undone its decline, which began back in 2002. Still, it represents a significant turning point for a currency whose long weakness had turned it into a source of rueful amusement for Americans.

Safe Port in the Storm

To the surprise of many observers, the greenback turned out to be a major beneficiary of the global flight from risky assets and the unwinding of bets based on borrowed cash, much of it in dollars. In a time of extreme financial stress, investors sought the relative safety of the world's reserve currency, and if possible, U.S. Treasury bonds.
The ever-widening scope of the crisis also helped the buck: It rapidly became clear that the U.S. is far from the only country with economic woes and hobbled banks.
For investors, the dollar's resurgence is proving a tricky puzzle. Some believe that the comeback will prove to be short-lived, given the enormous challenges facing the U.S. economy. But others say it's likely to endure well into next year as economies around the globe grapple with a sharp slowdown.
"We are roughly halfway through the rally in the dollar," predicted Stephen Jen, global head of currency research at Morgan Stanley, in a recent note. Mr. Jen thinks the dollar could face a harder slog in the second half of next year as the full costs of various government bailouts become clear.
For now, a stronger dollar is a welcome development for Americans traveling abroad, who had become accustomed to seeing their dollars buy less and less on each trip.
But for some companies, it's less desirable. A stronger dollar means that American exporters' goods and services are more expensive for foreign buyers, reducing their competitiveness. It also represents a drawback for American multinationals. Their overseas earnings will be worth less when converted back into dollars, denting sales and profits.
The dollar's rally has also helped clobber one of the most popular investing trends of recent years: buying foreign stocks. For much of the last six years, U.S. investors got an additional bonus when putting money overseas. As the dollar declined, gains in foreign currencies would convert into more dollars, sweetening returns.

Overseas Stock Losses

Now the opposite dynamic is unfolding. Global shares have plunged and the dollar has surged against nearly all currencies (with the Japanese yen the major exception). So not only have foreign shares fallen, they're also worth less in dollar terms, magnifying the losses for U.S. investors.

The impact has been substantial in some cases: For instance, the MSCI Emerging Markets Index, which tracks stocks in developing countries, has fallen by half this year in local-currency terms. But translated back into dollars, it is down about 60%.
"The dollar has been the wind at our back for the past five years," says James Moffett, who manages the $3 billion UMB Scout International Fund. "This year it's been in our face."
Mr. Moffett adds that he thinks the currency-related pain for international stocks is nearly finished -- in other words, the dollar is unlikely to strengthen further from here.
Some see clouds gathering for the dollar as the massive programs to assist the ailing economy work through the system. The problem isn't necessarily that the U.S. fiscal deficit will increase. "Neither economic theory nor the historical record provides a clear link between fiscal stimulus and [currencies]," noted a recent report from J.P. Morgan Chase.
Instead, observers are focused on the actions of the U.S. Federal Reserve, which has expanded its own balance sheet, essentially creating money to fund a variety of new programs.
Once the economy starts to recover, the massive injections of cash by the Fed could cause rampant inflation, something that's bad for the dollar because it erodes a currency's worth. Others say the Fed will curtail liquidity before that happens, by raising interest rates or through other measures. For now, the Fed is trying to avert a different risk, that of deflation -- a vicious cycle of contracting credit and falling prices.
In the back of their minds, investors also worry about another scenario, in which foreign investors could lose confidence and scale back or stop buying U.S. assets. That would send the dollar plunging and interest rates soaring.

Investment Opportunities

Of course, that possibility remains remote. In some ways, what has unfolded so far is the opposite of such a crisis. Rather than shunning assets like U.S. Treasurys, investors have flocked to them in a sign that they continue to see them as a haven in an uncertain world.
For investors, the dollar's latest surge and murky future present a number of choices. There are a number of funds that aim to track the movements of various currencies against the dollar, including nine exchange-traded funds from Rydex Investments. Such instruments essentially involve taking a view on currency directions -- which is always risky.
If you believe that, in the long run, the dollar is likely to weaken, then one strategy is to own stocks or bonds denominated in other currencies. If the dollar loses ground, the returns will be worth more when converted back into dollars.
Bonds denominated in other currencies are a more direct way to bet on such fluctuations, since most of a stock's return comes from factors other than currency gains or losses.
Write to Joanna Slater at joanna.slater@wsj.com

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