Why the Dollar Insists on Bouncing in 2008

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If the U.S. economy is sinking, then why is the beaten-down dollar rallying right now?

Seems strange, but in reality there are five key reasons why the dollar is headed north this winter. For starters, we're seeing:

Higher inflation data - The Producer Price Index (which tracks inflation at the producer level) and Consumer Price Index (which tracks inflation at the consumer level) both showed much higher inflation lately than usual. . Foreigners have increased their purchasing in America due to the "cheap" dollar thus driving inflation higher.

Since inflation is creeping up, the U.S. Fed may have to stop cutting rates, and start fighting inflation. If the Fed stops cutting rates, the dollar will stop sliding further.

High euro and British pound exchange rates - At some point, a country's exchange rate gets too high for its own good and starts to hurt that country's export sector. This is exactly what's happening all over Europe right now. The euro shot above US$1.49 and the pound got over US$2.11. These "extreme" rates were killing their export prices.

So as this takes its toll on the economy, the exchange rate eventually drops to reflect the softer economy. When the exchange rate drops, it means that traders are selling euros and pounds. When traders dump European currencies, it boosts the dollar upward against it in the EUR/USD and GBP/USD pairs. So that alone causes dollar buying even though the U.S. economy still isn't in good shape.

Carry-trade unwind - "Carry-trading" involves buying a high-yielding currency against a low-yielding currency so that you profit from the daily interest differential. However, this strategy only works in a low volatility environment where high-yielding currencies are on the rise.

Lately, these "high yielding" currencies have been dropping because currency volatility has more than doubled. In such a high-risk environment, traders tend to dump "high yielders" for safer, low-yielding currencies. Just by selling, these traders are forcing money to flow away from these high-yielding currencies.

Where did the bulk of trading capital flow? Firstly, money flowed to the beaten down Japanese yen because traders borrowed yen the most to finance their carry-trades. Secondly, money flowed to the Swiss franc because the Swissie is the next most popular currency sold in carry-trades. Lastly, it flowed into the U.S. dollar because it's been so unusually beaten down.

Long story short, as the third most beaten down currency, the buck stands to profit when these carry-trades come undone.

Housing numbers are starting to stabilize - On Tuesday, the Housing Starts and Building Permits numbers were released. And the numbers basically met economists' expectations. The previous Monday, Pending Home Sales beat expectations. So we're starting to see some life come back into the housing market slowly. I'm sure it will be a bumpy ride with some negative numbers sprinkled in here and there.

However, just to have some numbers start to meet or beat expectations in the housing arena is a great sign. The most important numbers to watch out for will be the New and Existing Home Sales numbers. See how they come out and they'll paint a better picture of how the dollar will fare in 2008. Both of these numbers are important, but pay particular attention to the existing home sales because it's the broadest measure of the overall housing market.

Commodities stall temporarily - Commodities and the U.S. dollar trade somewhat inversely. So when commodities are going up overall, the dollar is going down. When commodities are declining, the dollar is rising.

Take a look at the CRB index to the left (which tracks a basket of commodities) and you'll see that it's broken its upward trend in the short term and has hit a "brick wall" of resistance around the 355 level. The U.S. dollar will continue to prosper if the CRB index can't break and hold above the 355 level.

As you can see, the "planets have aligned" in the dollar's favor for now. And I'm predicting the dollar will continue this short-term bounce well into 2008.

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tres bien.