Bucking a Trend: Why the Dollar Could Rally in 2011

Despite a likely third straight year of $1 trillion U.S. budget deficits, and the U.S. Federal Reserve's controversial quantitative easing program, the U.S. dollar has basically remained flat against the world's other major currencies. Compared to the British pound, it has barely budged over the past year, going from $1.6153 to $1.6093. At the same time, it fell a relatively small 4% against the Canadian dollar and went up 5% against the euro.

Admittedly, the dollar lost a substantial 10% of its value against Japan's yen, but unless you're willing to "park" your money in Japan's famously low-interest banks for almost no return, the yen is not a worthwhile option. By extension, that same drive for yield/return will probably discourage many institutional investors from trading in their dollars for yen.

If the dollar's resiliency in 2010 didn't surprise you enough, try this on for size: There's a decent chance the dollar may rally in 2011, rising in value against other major currencies. Here's why:

U.S. budget deficit reduction progress. First, it seems likely that there will be progress in reducing the budget deficit in 2011. That may be hard to believe, given that the Democrats and Republicans in the past week courageously said "you go first" regarding entitlement reform, but the important point is that the structure of the debate has changed. The debate is no longer focused on spending increases; instead, it's looking at how much will be cut and where the slashing will occur.
Analysis: Dollar bullish.

Euro-zone debt concerns. The European Union has made strides addressing its sovereign debt woes; for example, it's poised to increase the size of its bailout fund. Still, at least two large-debt nations, Spain and Portugal, remain under "24-hour observation." While the pair will probably will avoid a bailout, the chance that they might need one -- and the negative impact that such a bailout would have on the euro -- is likely to keep investors nervous about the euro for the next year.
Analysis: Slightly dollar bullish.

Dollar as global reserve currency. Eventually, globalization may lead to the adoption of several reserve currencies. In fact, the euro, yen, British pound and Swiss franc already play supporting roles. For the time being, however, institutional investors are not yet ready to abandon the dollar-dominated reserve currency system -- a status that continues to boosts the dollar's value.
Analysis: Dollar bullish.

U.S. economic expansion. Finally, there's the U.S. economy. After the longest and most painful recession since the Great Depression, the world's largest economy appears to be headed for a better-than-adequate performance in 2011. U.S.-based companies, including many multinationals, are lean, cash-flush (they've amassed about $2 trillion in cash), and are well-positioned to take advantage of the global growth cycle. That bodes well for earnings growth. And because these are largely dollar-denominated investments, it will increase demand for dollars.
Analysis: Dollar bullish.

So whether you're talking about the deficit reduction, Europe's debt woes, currency reserves or the multinational-led U.S. economic recovery, the stars appear to be lining up for a decent year for the dollar. Of course, the outbreak of another war involving the U.S., an unforeseen natural or man-made calamity (such as terrorism) or a major and sustained disruption in the flow of imported oil could all result in a bad year for the buck. But minus those, look for the dollar to hold its own in 2011.