Why the U.S. Dollar is Rising – And Why It's Still Doomed

Many have wondered - and rightly so - why the U.S. dollar is rising even though the U.S.Federal Reserve has done just about everything possible to debase the currency over the past five years.

Over the past two years, the U.S. Dollar index, which measures the dollar against a basket of major world currencies, is up by more than 12.6%.

Part of the answer is that most of the world's other central banks have pursued easy money policies similar to the Fed's. In the so-called "currency wars," the U.S. dollar has one major built-in advantage.

"The U.S. has never defaulted," explained Money Morning Chief Investment Strategist Keith Fitz-Gerald. "The world may hate our guts, but when all hell breaks loose, they all love our dollar."

Also helping to explain why the U.S. dollar is rising is that it remains the world's reserve currency - the money a majority of nations use to buy commodities such as oil -- and that the U.S. economy, for all its warts, is in better shape than most of the other developed economies in the world.

"The dollar the best-looking horse in the glue factory," Fitz-Gerald said.

So it wasn't too surprising that when the Fed recently hinted that it might start "tapering" its quantitative easing (bond-buying) policies later this year, the U.S. Dollar index spiked 3.1%.

But Fitz-Gerald said that investors still need to be wary of the stronger U.S. dollar going forward.

"It doesn't mean the risks have gone away," he said. "The Fed has added trillions to its balance sheet. The economic recovery is not strong enough. Debt is out of control at every level - government debt, personal debt, corporate debt."

Why The U.S. Dollar Is Rising And Why That's Bad

To get an idea of the true state of the U.S. dollar, it helps to look beyond its recent strength.

Since January 2002, for example, when the U.S. Dollar Index stood at 120.22, the dollar has fallen by 31%. And that's after its recent two-year rise.

Fitz-Gerald said that the real threat to the markets in the long run is what all the world's central banks have been doing in a desperate attempt to prop up their banks and stimulate asset values and their lagging economies.

"What they've been doing defies everything we know about money," he said, pointing out that at some point "it will end badly," though it's hard to predict when because the central banks are fighting so hard against it.

"The markets want to fix this, but they're not being allowed to fix it," Fitz-Gerald said, noting that we've had several "taper tantrums" in recent months that illustrate this. Any whiff that a central bank is losing control of the situation (Japan) or is intentionally considering backing off current policy (the Fed last month) has triggered massive stock market sell-offs.

Eventually, though, the markets will have the final say. And it won't be pretty.

"There will be widespread banking failures, the stock markets will readjust. It will be a rough ride," Fitz-Gerald said.

But despite the short-term pain, the purge will be healthy for the markets and the world's financial system. In fact, Fitz-Gerald said, had more banks been allowed to fail back in 2007-2008, the worst would already be behind us.

"There would have been 12 to 24 months of financial hell then we would have started to recover," he said. "We're going to find out that the cost of preventing those failures will exceed the cost of letting it happen."

How to Prepare for the Dollar's Eventual Demise

Despite the trouble looming in the U.S. dollar's future, Fitz-Gerald cautioned investors not to go to the sidelines.

"It's like Beowolf lurking in the shadows - he's out there, but in the meantime you have to live your life in the village," he said. "Ultimately, the dollar will fail, but in the meantime it's better to be long than wrong."

In other words, investors can disagree with the Fed's policies, but need to acknowledge that for now those policies are driving the market.

Despite the talk of tapering, Fitz-Gerald doesn't think the Fed will put the brakes on QE anytime soon.

"We can grab profits from the Fed's folly, but we also need to protect ourselves," Fitz-Gerald said.