Reports of dollar's demise have been greatly exaggerated

One of the most remarkable recent financial developments, a potential harbinger for global markets this year, has been scarcely remarked upon. It's the sudden, sharp recovery in the dollar. The surge, which began in early December, has taken the dollar - and the dirham, whose value is pegged to it - up about 5 per cent, leaving it with a what's-all-the-fuss-about loss of 3 per cent for 2009 against the euro, its main rival for the role of the world's reserve currency. Reports of the dollar's death - uttered continually as the currency was falling - have been greatly exaggerated.

The latest recovery appears more forceful than others made during the last year, and it may prove less fleeting. If a rising trend becomes firmly established, it could have significant consequences, especially in the Middle East, because of the dollar's relationships with several key assets that are important to investors there. That said, any portfolio tinkering at this point is premature. The rebound may turn out to be a colossal fake-out that evaporates as swiftly as it materialised. Even if the rally gets legs, any impact would depend on the underlying causes and would have to be considered in the context of other factors driving markets and economies.

Relationships between the dollar and various investments are simple - in simple times. A rising dollar tends to reduce the prices of hard assets denominated in the currency. The two most notable examples are oil and gold. Sure enough, when the dollar was making modest recoveries in the first half of 2009, those commodities showed weakness. This time around, gold spent December correcting a large portion of its advance of the previous few months, although it ended the year with a substantial gain. Oil did better, ending the month flat and near its highest level in more than a year.

The resilience suggests that commodities will withstand the headwind from a robust dollar. That ought to be good news for the economies and stock markets of oil exporting countries in the Middle East as long as the currency does not move up at so fast a pace that it curbs energy demand in Europe and Asia. How much the dollar rises may be less important than why. A flare-up of the risk aversion that was endemic a year ago and lured investors into what they saw as the comparative safety of the US economy would be the most ominous source of strength for the dollar.

A shunning of risk likely would reflect doubt about the staying power of the global recovery and might become a self-fulfilling prophecy. A new spirit of caution would not bode well for emerging stock markets, including those in the Middle East, and a second dip into recession would almost certainly knock the starch out of the rally in oil. The dollar might also move higher due to a surge in inflation expectations and interest rates on Treasury bonds. That outcome would amount to the bill coming due for the enormous spending undertaken by the Bush and Obama administrations to try to keep the US economy afloat.

If that scenario were to play out, the higher returns on Treasuries would attract global investors and prop up the dollar. The uncomfortable inflation backdrop would put a floor under commodities and support stock markets in oil-reliant economies. Such a backdrop might have the opposite effect on the stock market in Dubai, an economy with a massive debt overhang and little oil or other commodities to sell. The cost of servicing the emirate's debt probably would be higher, and the rising dollar would make Dubai property more expensive for foreign buyers, although higher inflation expectations might give a lift to real estate markets there and elsewhere.

What are the chances that events will unfold this way, that the dollar's strength will persist? The consensus among economists is that the dollar's gains will be erased. Then again, they were nearly unanimous in expecting further weakness before the recent surge. As for rising Treasury rates and inflation expectations, the massive and expanding US deficit is certainly well known and shouldn't take anyone by surprise. What investors may be underestimating is the impact on rates from a withdrawal of Federal Reserve aid to credit markets, which seems bound to happen sooner rather than later. The persistent strength in commodities is a sign of lurking inflation concerns that may become more conspicuous after credit markets are functioning on their own.

As 2010 gets under way and you make your usual resolutions about losing weight or giving up smoking, consider adding one to the list about watching what the dollar does and why. It could help you enjoy a more prosperous new year, or at least avoid a costly one. Conrad de Aenlle writes from Los Angeles about investment and personal finance issues. His blog on contrarian investing for MoneyWatch.com, "Against the Grain," can be found at http://bit.ly/NjaBa