Buying dollars, not selling them might be the best way for currency investors to benefit from a US economic slowdown which could haunt the global economy into next year.
The world economy looks set to cool towards 2007, partly because major central banks are tightening the liquidity tap to fight inflation. The US economy is already slowing, with growth in the second quarter coming in at less than half the pace at the start of the year.
"If you talk about US economic slowdown relative to the rest of the world, you are in effect saying you are expecting the US trade position is going to improve. That outcome in itself is a dollar positive," said Steven Pearson, chief currency strategist at HBOS Treasury Services.
Dollar bears say the huge US trade deficit could weigh on the currency, if the United States has difficulty in attracting sufficient foreign funds to finance it.
"The other dollar positive from a globalisation of a slowdown is that the expected narrowing of US over Europe/Japan short-term interest rate spreads will not materialise. Those long on (euro, yen) on the idea that rate convergence will lessen the (dollar) carry costs will be wrong."
The Federal Reserve left its interest rates steady at 5.25 percent, pausing its two-year tightening campaign. The European Central Bank raised rates to 3 percent last week, with one or two more further rate hikes expected.
Japanese interest rates are expected to stay low, rising perhaps to 0.5 percent in the next several months after the first rate hike in six years to 0.25 percent.
The International Monetary Fund expects the world economy to post its fourth year of expansion above a 4 percent annual rate this year. But major central banks are withdrawing liquidity put in place after the 2001-2002 equity bubble burst. Merrill Lynch economists say there is now about a 40 percent chance of a recession in the first half of 2007.
Concerns for tighter liquidity spooked financial markets in May to June, with stock and commodity markets world-wide tumbling and higher-yielding emerging market assets being sold off.
"That was a dry run on a small scale of what will happen in a global recession. These markets got absolutely hammered and the dollar went up a lot in that period," Pearson said.
Credit Suisse analysed the dollar's performances during pauses and peaks in Fed rate cycles in the past 20 years. "We see since 1994 three peaks. We've seen March 1995, May 1997, June 2000 and they were positive for the dollar and the dollar tended to rise," said Umberto Alvisi, currency strategist at Credit Suisse.
"If we think there is not going to be a financial crisis, we might see the dollar doing fairly well."
Morgan Stanley says for the past 10 years Asian, dollar-bloc and emerging market currencies tended to outperform the dollar when global growth was strong and the equity markets were buoyant.
"Uncertainty over whether there will be a soft or a hard- landing should be supportive for the dollar, or at least the dollar will enjoy a risk premium associated with uncertainty," said Stephen Jen, chief currency strategist at the bank. Jen says the euro might see a short-term boost but that will in turn weigh on the euro zone economy and contribute to the global slowdown.
He estimates it takes around 9 months for an initial impact of the ECB to come through. The ECB has tightened 100 basis points in the latest cycle.
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