The fundamentals argue…

The early 21st century has not been kind to the U.S. economy, and this has prompted investors (as well as some central banks) to turn away from the dollar toward the euro and the other European currencies.

The recovery from the tech stock bubble (which burst in the spring of 2000) and the U.S. recession that started in 1999 was not easy. The American twin deficits ballooned and, as most economists are happy to regurgitate, that’s terrible for the economy. The U.S. military expeditions in Afghanistan and Iraq accelerated those deficits, and the trading world was happy to follow the obvious script and dump the greenback. Then hurricane Katrina wrought unprecedented damage on the Gulf Coast in 2005, which added further weight to the budget deficit and probably will continue to do so for years to come.

The record deficits such as the record trade deficit in long term. The odds of showing a significant improvement remain extremely low in an age when exporting production out of the country has become an obsession.

Assumptions that China — the new rising economic power that has surged on the back of production aimed at the gargantuan U.S. consumer market — will stop buying the U.S. debt are a tad farfetched, or at least premature. The odds are extremely low that China will jeopardize its economic growth and future just to show the world it has come of age.

The same applies to Japan, the original Asian tiger. Japan has pledged, and rightfully so, to hold on to the massive amounts of U.S. debt paper it now owns. After all, how many Lexus automobiles have you seen in Asia or Europe? Japan must preserve at all costs the generous, enormous, and debt dependent U.S. market.

Even legendary investor Warren Buffett caught the forex bug, selling approximately 35 billion U.S. dollars (primarily against the euro) in 2004 and making a handsome profit on it as well. However, 2005 was a different story.

Meanwhile, the Federal Reserve noticed faster than probably anyone else the incipient inflation buildup in the recovering U.S. economy. Former Fed Chairman Alan Greenspan quickly pulled the trigger in the middle of 2004 and hiked rates steadily. True, the increases were all only 0.25 percent each (as the fashion of the past decade Interest rates are supposed to support the local currency, and for a change this rule of thumb worked well. Of course, forex means “exchange of different currencies,” so the market is not only watching U.S. interest rates, but rates in all the G7 countries, and many others. Interest rate differentials have supported the dollar for several months and will do so into the intermediate-term future.

While the Federal Reserve has mounted a steady tightening cycle since the middle of 2004, the Bank of England, which started its own cycle first, was forced to cut rates in August 2005 in an attempt to mildly jolt its weakening economy. Among the G7 economies, only Canada followed the U.S. example and hiked interest rates, and it did so with large lags in time and size.

The big but inconsistent Eurozone economy remains mired in structural problems, while the Bank of Japan’s monetary policy board decided in July to change its basic lending policy and officially raised rates for the first time in six years to 0.25 percent. However, it hinted additional tightening would be minimal, which ensures rate stability. The dollar should further benefit, but with a lag, which in this case is the time between the start of the rate-hiking cycle in June 2004 and the start of the dollar uptrend in January 2005.