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Why the U.S. dollar is ‘the best horse in the glue factory’

An employee of the Korea Exchange Bank counts money next to stacks of one hundred U.S. dollar banknotes at the bank's headquarters in Seoul, August 11, 2011.

Jo Yong-Hak/Reuters

Investment prognosticator Don Coxe had an intriguing chart accompanying his latest webcast. It showed a graph of the U.S. dollar index marching upward, alongside the caption "The next petro-currency?"

Something good is definitely happening to the much-maligned U.S. buck. The dollar is unexpectedly rallying, up about 5 per cent against a basket of other major currencies since the start of the year, raising the obvious question of why, and whether the trend might continue.

Currency moves are particularly great for money-making because once they're firmly established, they usually go on for years. Currency trading also allows for exceptional amounts of leverage through futures and the inter-bank market, providing huge profits for the correctly positioned, nimble speculator.

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The rise in the U.S. dollar goes against conventional wisdom in much of the financial community. Many investment pros have been on currency debasement alert, worried that the U.S. dollar would self-immolate in the bonfire of the fiat currencies. The thinking has been that Fed chief Ben Bernanke would be pounding down the value of the dollar through his unconventional monetary policy of quantitative easing.

QE, as it's known, is the first step in creating money out of thin air by the Fed. The U.S. central bank has been conjuring up about $85-billion (U.S.) of fresh money a month, an astonishing $1-trillion annual rate.

Meanwhile, payroll tax hikes brought about by the "fiscal cliff" negotiations, and worries over the automatic U.S. spending cuts that went into effect on March 1 should have been been slowing the economy, further undercutting the value of the dollar.

If two major negative trends like this aren't enough to sink the dollar, something must be putting a strong bid for the buck into the market. To my mind, the most convincing explanation is that the market is starting to recognize that the U.S. dollar is becoming a petro-currency, an advantage that isn't enjoyed by the yen and euro, its major rivals.

In practical terms, it means the growing production of relatively cheap oil from shale plays, and the bonanza provided by cheap natural gas, are lifting the U.S. economy and therefore the dollar.

Mr. Coxe, in his webcast, figures cheap U.S. energy has taken off the table the possibility that global growth will be choked by soaring energy prices, a big plus for the international economy.

But the re-emergence of the U.S. as an energy powerhouse is having other, far-reaching impacts. Just look at the share price of Methanex Corp. The TSX-listed methanol producer is expanding production in the U.S. to take advantage of low natural gas prices, its main feedstock. The shares are up more than 20 per cent this year.

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Thanks to cheap gas, petrochemical and fertilizer production in the U.S. is booming. While cheap energy is an obvious elixir for chemical-related businesses, it aids manufacturing, too, driving down costs and making the U.S. more internationally competitive. Cheap natural gas means inexpensive electricity, a bonus across the entire economy.

With a more competitive economy and reduced oil imports, the U.S. trade balance, in a chronic deficit for decades, is less of a worry for dollar holders.

The U.S. dollar has been hated for so long there are few currency bulls, a good sign for those on the lookout for contrarian ideas. One of the few has been Gary Shilling, founder of an eponymously named U.S. money management firm. In his accounts, he's long the dollar by shorting the yen, euro and Australian dollar. He's also long the Japanese stock market, which will benefit if the yen continues to fall against the dollar.

In an interview, Mr. Shilling quips that the U.S. dollar is "the best horse in the glue factory."

In other words, the alternatives are even worse. Japan is attempting an even more aggressive debasement of the yen, and the European Central Bank stands ready to print unlimited amounts of euros should the need arise.

The U.S. economy is also doing far better than recession-mired Japan and Europe. In China, the country is struggling to transform from export-oriented growth to domestic demand. The U.S. currency is likely to remain the world's safe, should financial instability resume, another plus.

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"I think the U.S., with the tradition of innovation and entrepreneurial activity, has probably got the leg up" over other countries, Mr. Shilling says. Although there will be occasional pull backs, the trend favouring the U.S. dollar is likely to "be sustained for some time," he predicts.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More

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