Gavekal’s five reasons to keep faith with the dollar…

As many currency strategists have noted in recent days, the dollar does indeed appear to be rallying on Europe’s – and the UK’s – woes; or as the FT’s currency correspondent Peter Garnham puts it:

This month’s dollar rally was mainly due to the realisation that the negative effects of the credit crisis were spreading beyond the US faster than previously thought, rather than any renewal of faith in the US economy itself…

So it seems a good time to ask: what could we expect if good news from the US is thrown into the brew?

That is precisely the question that the folks at Gavekal, the HK-based research and investment group, pose in their latest client note as they note that the dollar’s recent strength can largely be attributed to bad news coming from Europe.

Investors are lessening their exposure to the euro amid increased signs of economic slowdown, fears of which are “aggravated every time Jean-Claude Trichet makes some vacuous remark (which unfortunately happens basically every time he speaks)”, says Gavekal. [An aside here, as discussed in Monday's FT, not everybody thinks Trichet is useless; far from it - some even think he should be destined for greater things.]

Either way, imagine the movement on the dollar if there was actually some positive news out of the US. Most investors are not holding their breath on this front, but Gavekal notes there have already been a fair number of positive developments:

1. The market is shrugging off bad news on Fannie and Freddie. On Wednesday, shares in Fannie dropped 20 per cent and Freddie shed 32 per cent as speculation increased on a possible government bailout. Yet, despite this, US equities performed well – indeed S&P500 financials actually rallied 1.6 per cent and diversified banks rose by a notable 3.7 per cent. This has psychological significance, in Gavekal’s view: investors are now focusing on the positives and less prone to panic.

2. US exports are on an upswing, expanding at rates not seen since the 1980. While some argue the trend will peter out if the dollar continues to rebound, the truth is more complicated. After all, says Gavekal, we are living in the globalised new age, where companies can call a bank and buy a hedge to protect themselves from fast-moving forex trends. This means it takes quite a few years before a currency’s trend is reflected in exports, and explains, for instance, why the euro’s rally took a very long time before it began weighing on Germany’s stellar exports. Moreover, the dollar has a long way to go before it gets “expensive”.

3. It is a US election year — yet protectionism has not reared its ugly head. It is hard to win a US election without vowing to protect US jobs from overseas competition, and regularly bashing China. Yet recently, protectionist rhetoric has been relatively light, especially against China. Whether due to the Sichuan earthquake or the Olympics … or surging US exports, it is a positive sign.

4. Sentiment is improving. Consumer confidence remains near historic lows, but is improving. A number of polls issued this week – from ABC/Washington Post to the Bloomberg/LA Times poll – show that Americans are regaining some optimism about economic prospects. Falling gas prices is obviously one catalyst – and you can expect oil to continue to head south.

5. The US tax rebates have not been spent – and unlike a month ago, it no longer looks like the rebates will go straight into the gas tank.

So, concludes Gavekal, it’s time for a bullish dollar call. “Indeed, as the short-USD trade unwinds, many foreign borrowers will scramble to repay their dollar debt; and if there is “good news” from the US, panic dollar-buying could ensue….”

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