4 Reasons The U.S. Dollar Rally Will Likely Continue

Sep.14.11 | About: PowerShares DB (UUP)

The U.S. Dollar has been rallying sharply since the beginning of September. Although the secular downside pressures on the U.S. Dollar are well known, a variety of fundamental factors support a continued rise in the greenback at least in the near-term.

The U.S. Dollar has been locked in a steady decline over the last decade. It was during the economic downturn following the bursting of the technology bubble in January 2002 that U.S. policy makers shifted their strategy to a weak dollar policy. And since that time we’ve seen the U.S. dollar decline by over -25% on a nominal broad index basis.

A variety of factors have further fueled this Dollar decline since the outbreak of the financial crisis in late 2008. The U.S. Federal Reserve has eased monetary policy aggressively through lowering interest rates to zero and engaging in two rounds of quantitative easing (QE) that have significantly increased the size of its balance sheet. At the same time, the President and Congress have applied dramatic fiscal policy measures to increase government spending in an effort to support and stimulate the economy. These actions helped push the Dollar back into its downtrend following a brief but sharp flight to safety spike in the following the financial crisis in late 2008 and early 2009.

After grinding along a bottom since early May, the U.S. Dollar has shown renewed life in recent weeks. Since the beginning of September, the U.S. Dollar as measured by the PowerShares DB US Dollar Index Bullish ETF (NYSEARCA:UUP) has rallied by +4%. And despite the continued long-term pressures on the U.S. Dollar, several factors are supportive of continued Dollar rally over the short-term to medium-term.

1. Euro Crisis

The Euro currency has outperformed the U.S. dollar for the last several years behind the fact that the European Central Bank has maintained tighter monetary policy. This includes a higher interest rate currently at 1.5% that was hiked twice by 25 basis points each in 2011 versus the U.S. Federal Reserve that has kept interest rates near 0% throughout the crisis. This higher interest rate has attracted investors seeking to capitalize on this additional yield.

But as the sustainability of the Euro currency comes increasingly into question as the European Debt Crisis continues to unfold, investors may be forced to abandon this trade. And as the Euro continues to weaken, this would have a particularly profound impact on the UUP, whose underlying USDX futures contracts are allocated by 57.6% to the Euro currency. This is by far the largest allocation and more than four times the next highest allocation to the Japanese Yen at 13.9%. Thus, if the Euro currency continues to deteriorate, those allocated to the U.S. Dollar would experience a pronounced impact.

2. Safe Haven Status

Despite its fiscal problems and aggressive monetary policy, the United States is still widely regarded as a safe haven destination during times of crisis. Even when the United States banking system was at the epicenter of the crisis back in late 2008, investors flocked to the United States and the U.S. Dollar for safety. The same occurred in 2010 after the end of QE1, as investors flocked to the U.S. Dollar once the problems in Greece began bubbling to the surface in April 2010. The fact that global instabilities continue to persist, the highly liquid alternatives to the Dollar are lacking and the epicenter of the problem now resides in Europe are all factors supportive of another dollar rally if crisis were to erupt again.

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3. Swiss Franc Combating Its Safe Haven Status

Switzerland had recently been a preferred destination for safety seeking investors. In many cases, capital was migrating to the Swiss Franc at the expense of the U.S. Dollar. But on September 6, the Swiss National Bank (SNB) made the declaration that it would make an aggressive policy intervention by pegging its currency to the Euro. Whether the SNB is actually successful in its intervention or not, this action essentially takes the Swiss Franc off the table as a safe haven. With one less destination in a world that has only a few options for safety – Gold (NYSEARCA:GLD), the Japanese Yen (NYSEARCA:FXF) and the U.S. Dollar (UUP) being the only main alternatives – this will likely push more capital toward the Dollar.

4. Reins Starting to Get Pulled on U.S. Fiscal and Monetary Policy

Policy makers in the United States have a long way to go in cutting back on spending and becoming more hawkish. However, after years of aggressive spending and monetary stimulus, policy makers are under increasing pressure to stop and begin working to get the house in order. The President and Congress are under growing pressure to not only stop new spending but to cut back on existing spending to reduce the budget deficit and the national debt. And the U.S. Federal Reserve and its independence is now under intense scrutiny, which will likely lead to more conservative and prudent policy actions going forward. This developing trend is bullish for the U.S. dollar as long as it is sustained.

All of these factors are supportive of a continued rise in the U.S. dollar, at least in the near-term. As long as the situation in Europe continues to deteriorate and global economic conditions remain uncertain, the U.S. dollar should find support. And whether this reversal in the dollar can continue in the long-term will depend on the true conviction of U.S. policy makers to follow through on the changes they have only begun to commit to in recent months.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long GLD.