Crises have a way of separating strong business models from sub-par ones. Similarly, they sometimes invalidate theories institutional investors and economists have adhered to for generations.

One example of the latter concerns the dollar. The Federal Reserve's balance sheet has increased to $3.5 trillion from $800 billion in September. Meanwhile, the U.S. budget deficit for fiscal 2009, will likely exceed $550 billion (pdf) and could top $1 trillion; it could top $1.2 trillion next year.

Had the aforementioned debt increases occurred in Brazil, Mexico, or Argentina, the result would have been a flight of international investors out of local investments, accompanying respective currency runs, and an ensuing domestic crises.

The impact of the increased debt on the United States? By almost all measures, it's been mild. Since September, the dollar has risen about 15% and 20% against the euro and British pound respectively. Meanwhile, borrowing costs for the U.S. government have trended lower, with interest rates on the 10-year and 30-year bonds falling to 2.79% and 3.29% respectively.

True, the dollar has fallen 13% versus Japan's yen, as institutional investors, unable to productively invest borrowed, low-interest-rate yen, returned that money to Japan, but by and large the dollar has remained firm amid the nation's worst financial and economic crisis in at least 40 years.

Many economists had expected the dollar to weaken. Economist Peter Dawson was one of them.

From fiscal and economic fundamental standpoints, this is something that shouldn't be happening. Or at least it wouldn't be happening in normal times.

But as investors know, and as currency traders will quickly point out, these are not normal times.

Safety is paramount

The dollar continues to hold its own, for the most part, versus the world's other major currencies, despite the fact that the United States is likely to bear the largest economic and fiscal costs stemming from the financial crisis and consequent recession. The dollar has held on to gains recorded earlier in the month against the euro and the British pound, at about $1.2670 and $1.4720, respectively, losing ground only against Japan's yen, at 96.60 yen.

Currency Trader Andrew Resnick said the dominant theme in the currency markets -- as in almost every market these days, it seems -- is risk aversion and a flight-to-safety.

"The dollar is clearly benefiting from the flight-to-safety. On an economic fundamentals basis, the dollar should not be this strong and U.S. interest rates should not be this low, but fundamentals are not ruling the day now," Resnick said. "Safety and the protection of capital is." Resnick added that he was presently flat, or had no open currency positions.

The dollar and yen surged Friday -- with the yen the clear winner head-to-head versus the dollar -- as traders and institutions added both currencies in a flight-to-safety on concern that all of the world's major economies will fall into a recession at the same time.

The dollar surged 3 cents versus the euro to $1.2642 and 6 cents versus the British pound to $1.5606.

The yen strengthened 4.7 yen to 92.64 versus the dollar and about 10 yen to 144.73 yen versus the British pound.

Institutions raise cash in dollars, yen

Currency Trader Andrew Resnick told BloggingStocks Friday, this morning's flight-to-safety is not solely due to economic fundamentals, which suggest slowing growth in the world's major economies, but also hedge fund / investment fund de-leveraging and closing out of losing stock positions.

"We're seeing many things happen at once, and that's producing these enormous moves. First, the carry trade [where traders borrow yen and invest it elsewhere] is unwinding. Leverage for investing purposes is declining as a trading strategy," Resnick said. "Second, major players are raising cash to cover redemptions, which is also causing stock markets globally to plunge."

"Third, we're seeing a re-pricing of risk to the higher, which is forcing some funds to raise even more cash, boosting the dollar," Resnick said. "Some of the moves are cash-necessary moves, but many are clearly panic-based, with traders exiting positions that have little chance of succeeding if the global economy continues to slow."

Here's an icebreaker for your next cocktail party or dinner party. (This one is sure to impress your friends and colleagues even more than explaining the market and economic significance of credit default swaps.)

Q: What's the strongest currency in the world?

Well, let's evaluate the world's major currencies and hone in on the answer.

• The dollar -- For the last few decades, the dollar was the world's strongest currency. After all, it is the world's reserve currency. However, recent history has not been too kind to the dollar -- the dollar's value has declined throughout the decade -- and the near-term outlook does not look good, either. Massive government spending to both end the financial crisis and put the U.S. economy on a sustainable growth track means additional inflation, if not dollar devaluation, is likely. Nix the dollar as the world's strongest currency.
  

• The British pound -- At one point in history, the sun never set on the British Empire, and the pound was the world's reserve currency. Although the pound has been strong this decade, likely additional interest rate cuts and fiscal stimulus to jump start the economy of Her Majesty's Kingdom, as John Lennon would refer to his native land, means the pound is likely to lose value in the year ahead. Nix the pound as the world's strongest currency.
  

• The euro -- The euro has challenged the dollar for reserve currency status this decade, and has gained versus the buck for most of that time, but you guessed it: the heavy hand of the financial crisis is beginning to take a toll. For example, Germany alone has approved a 650 billion euro (or $500 billion) bank rescue plan. That's equivalent to the U.S. putting in place a $2.5 trillion plan. Wow. Let's hope Germany doesn't have to use most of it. Of course, the euro zone is more than Germany, but severe stagnation in Germany suggests several more interest rate cuts by the European Central Bank. Nix the euro as the world's strongest currency.

The stance of currency traders as the U.S. Treasury's $700 billion bailout enters a House/Senate conference committee before floors votes and a transmittal to President Bush's desk? Stand aside, for now.

True, the dollar was holding its own Thursday at mid-day against the world's other major currencies, and the Dow was up about 250 points to 11,077 in what some called a 'euphoria rally,' but caution remains the order of the day, regarding the dollar, so says currency trader Andrew Resnick.

"There are still too many unknowns regarding the bailout bill to make an informed conclusion regarding the dollar's prospects at this juncture, so the best stance is standing aside," Resnick said. He added that he was presently flat, or had no open currency trading positions.

For the record, the dollar was slightly higher, up about one-half cent to $1.8401 versus the British pound, but down a quarter-cent to $1.4645 versus the euro. The greenback was also up about one-half yen to 106.56 versus Japan's yen.

The above moves are "statistically insignificant," given the basket of fiscal, monetary, financial sector, and economic unknowns relating to the United States economy, Resnick said.

"We won't know the dollar's fate until we know how much money the U.S. Treasury will spend, in what increments, its primary method of funding, what assets it will buy and at what prices, and how much money the [U.S.] government will have left to deal with other issues," Resnick said. "These are enormous issues, so the situation will remain clouded until we know more."

The initial analysis regarding the dollar's latest move suggests this dollar rally has legs, but don't write or e-mail home just yet. "We have to take things one day at a time with this dollar move," currency trader Andrew Resnick told BloggingStocks Thursday.

Discretion -- yes, the better part of valor -- is advised because the dollar's rally "is not being driven by robust U.S. economic data or by a conviction that all is well financially in the United States, but by sentiment that Europe's economy is trending toward a recession," Resnick said.

That sentiment propelled the dollar to a 1-year high versus the euro Thursday, good for a 1 cent improvement to $1.3911. The dollar also strengthened about a quarter-cent to $1.7515 versus the British pound.

Resnick added that the market "is basically factoring-in an interest rate cut by the ECB at its next meeting in October." The European Central Bank kept its key, short-term rate, the refinance rate, the same at 4.25% at its September meeting.

The comeback of the beleaguered dollar continues.

The dollar strengthened to a six-month high versus the euro Tuesday, and also rose against the world's other major currencies on a growing consensus in foreign exchange circles that global economic fundamentals are shifting in favor of the greenback.

The dollar strengthened about 1.5 cents to $1.4465 versus the euro, and about 1.4 cents to $1.7877 versus the British pound Tuesday at mid-day. The buck also gained one-half yen to 108.62 versus Japan's yen.

Pivotal for dollar: Europe, Asia GDP

Further, although Tuesday's dollar catalyst was the realization that Hurricane Gustav would cause considerably less-than-forecast damage to Southeast U.S. oil production and the refinery infrastructure, trader Andrew Resnick told BloggingStocks the longer-term focus remains regional GDP growth.

"With Hurricane Gustav out of the way, sentiment's building that this dollar rally has legs. European growth has slowed to recession levels, and China's economy has slowed as well. For Europe, lower interest rates are likely to follow, and that's dollar bullish," Resnick said. Resnick added that he expects the Bank of England to cut its benchmark interest rate by a quarter-point to 4.75% when it meets September 4. He doesn't expect the European Central Bank to lower its 4.25% refinance rate on September 4, but that stand-pat policy may change to accommodation, later this fall.

Some market signals are well-known and easily understood. Others are arcane and more-complex, but just as telling.

There's mounting evidence that the "carry trade" is ending, or that at least institutional investors are decreasing their use of it as an investment tactic.

In a carry trade, investors, especially institutional investors, borrow funds in a country with a low interest rate (or borrowing cost) and buy assets in a country where returns are higher. The investment can take many forms, including stocks, bonds, funds, or even the higher-interest currency itself.

Carry trade: A growth confidence indicator

Now, investors/readers may legitimately ask, Why is it important to know what's happening to the carry trade?

Economist Peter Dawson told BloggingStocks that it's important to monitor carry trade flows and data because it's one indicator of investor confidence in a market's ability to produce a return on equity, and by extension, in its economy to grow.

In other words, the carry trade abounds when investors are confident; it wanes when they're not, he said.

The dollar Friday was on course to record its fifth consecutive weekly gain, propelled higher by the prospect that economies in Europe may be later in the recession/expansion economic cycle than the United States.

The above suggests the Bank of England and the European Central Bank will have to cut interest rates -- itself a bullish factor for the dollar -- with the U.S. economy recovering sooner than the economies in the United Kingdom and euro-zone -- another dollar-bullish circumstance.

On Friday, the dollar strengthened 1.5 cents to $1.4675 versus the euro, and about seven-tenths of a cent to $1.8632 versus the British pound. The dollar also rose about 1 yen to 110.61 versus Japan's yen and about one-half cent to $1.0988 versus the Swiss franc.

From dollar-bear to dollar-skeptic

Currency Trader Andrew Resnick said he's not a dollar bull yet, but the changing global economic landscape has moved him from the dollar-bear category to "the dollar-skeptic category."

"Clearly, fundamentals are shifting in favor of the dollar. Global growth is slowing, taking pressure off commodity prices. Export gains are lowering the U.S. trade deficit, and there's now a better than 60% chance Europe [including the U.K.] will have to cut interest rates," Resnick said. "Those are the best fundamentals for the dollar in about three years." Resnick added that he's presently flat, or had no open currency trading positions.

The dollar was on-pace to record another weekly decline Friday - - undoing the gains against the euro and pound earlier this summer- - as traders and analysts debated the likely next step for the U.S. Congress and/or the U.S. Federal Reserve on the heels of possible additional massive, mortgage-asset-related write-downs by Fannie Mae and Freddie Mac.

The dollar traded at about $1.5888 to the euro Friday at mid-day, down about 1 cent, and also within about 1 cent of an all-time low versus the euro. The dollar also traded at $1.9878 to the British pound, also down about 1 cent, and off about 1 yen to 106.09 versus Japan's yen.

Currency trader Andrew Resnick said that given the dollar's decade-long slide versus the world's other major currencies, it's difficult to fathom further dollar declines, but that's what the economic fundamentals suggest.

"From one perspective, you have to ask, at what point do central bankers say the dollar's slide poses serious risks of commodity prices rises and inflation, with negative consequences for global growth?" Resnick. "On the scale of competing demands, you can make a strong argument that the dollar can not be permitted to slide much further."

However, Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), which face additional losses, Bloomberg News reported Friday, could come under full control, also called conservatorship, of government regulators, or receive bridge loans from the U.S. Congress or the Fed, Resnick said, absent a private equity investment. In any event, if Fannie's and Freddie's additional losses hit key levels, "we're looking at another enormous government obligation, and that's not good news for the dollar," Resnick said. "It means more dollars in circulation, which combined with the weak U.S. economy, will drive the dollar lower."

Resnick added that he presently is short with the dollar in the euro / dollar, British pound / dollar, and yen / dollar currency pairings.

Citigroup decided to sell its German retail banking division to France's Credit Mutuel for $7.7 billion as the financial behemoth continues reeling from the mortgage loan mess. In addition, analysts speculated that the European-region probably shrank for the first time since the single-currency Euro was formed almost 10 years ago.

In Japan, Shinsei Bank agreed to buy General Electric's consumer financing arm for $5.4 billion as GE continues to seek the sale of non-core operating units, such as its global appliance business months ago.

Below is a foreign market review for this morning:

European markets:

• The Dow Jones Euro Stoxx 50: at 2,819.21, down -14.51 (-0.51%)
• The FTSE 100 Index: at 5,391.40, down -15.40 (-0.28%)
• The DAX 30: at 6,234.31, down -70.69 (-1.12%)
• The S&P/MIB Index: at 28,590.00, down -181.00 (-0.63%)

Asia/Pacific markets:

• Singapore Straits Times: closed at 2,926.84, up 25.26 (0.87%)
  
• Nikkei 225 Average: closed at 13,039.69, down 27.52 (0.21%)
  
• The S&P/ASX 200 Index: closed at 4,979.90, up 42.50 (0.86%)
  
• Hang Seng Index: closed at 22,184.25, up 362.77 (1.66%)

In a move that surprised almost no one, the European Central Bank increased its key interest rate, the refinance rate, a quarter point to 4.25%. The increase brings the refinance rate to its highest level in seven years.

The currency market, which for the most part had already factored-in the ECB rate increase, did not react initially following the decision. The euro was virtually unchanged versus the dollar at $1.5882.

The other major currency pairings also held their ground. The dollar was unchanged against the pound at $1.9884 and the dollar rose slightly, up 0.10 yen to 106.25 yen, versus Japan's yen.

Economist: Trichet 'jumped the gun'

London-based economist Mark Chandler told BloggingStocks Thursday the ECB's decision was no surprise, but that doesn't decrease his disappointment with the ECB's stance.

"I afraid I'm going to really disagree with this one. I understand where [ECB President Jean-Claude] Trichet is coming from, but he's jumped the gun from my perspective. He could have waited another quarter," Chandler said. "There's a real concern now he's going to throw Europe into a recession like America, and if the dollar continues to fall against the euro, his rate increase won't lower inflation all that much. I don't like that bargain at all."

The dollar Friday was poised to record its largest weekly gain versus the euro in three years, on a growing consensus that the U.S. Federal Reserve will increase interest rates soon to check rising U.S. inflation.

The dollar traded up about one-half cent to $1.5372 versus the euro early Friday afternoon - - a level that if sustained at the New York close at 5 p.m. EDT would give the greenback its biggest weekly gain since early 2005, Bloomberg News reported Friday.

The dollar also rose Friday against the other major currencies. The dollar increased about one-half cent to $1.9494 versus the British pound, and about sixth-tenths of a cent to $1.0476 versus the Swiss franc. The dollar was unchanged versus Japan's yen at 107.90 yen.

So much for that nascent dollar rally.

The dollar fell against the world's other major currencies Tuesday after the International Monetary Fund cautioned that the U.S. housing slump still poses "serious risks" to financial markets and ZEW President Wolfgang Franz said he thought the ECB would increase interest rates in the near future, Reuters reported Tuesday.

The dollar fell 1.2 cents to $1.5649 versus the euro, about 1.5 cents versus the British pound to $1.9642, and about one-quarter yen to 104.10 versus Japan's yen.

Earlier in the day, IMF First Deputy Managing Director John Lipksy, in prepared remarks, said the IMF still sees "serious risks" to the financial market from the U.S. housing slump -- the U.S.'s worst housing decline in more than 15 years. Lipsky said the housing slump in the world's largest economy is yet to run its course.

Meanwhile, ZEW President Wolfgang Franz jolted the currency market Tuesday by saying he thought the European Central Bank would increase interest rates in the near future.

The dollar rose Monday against the world's other major currencies, despite the fact the European Central Bank's president reiterated his concern about rising euro-zone inflation, which suggests there's little chance for an interest rate cut soon on the continent.

The dollar rose about 1 cent to $1.5511 versus the euro and about 1.2 cents versus the British pound to $1.9455. The dollar also gained about one-half yen to 104.68 versus Japan's yen.

The dollar rally occurred despite the fact that ECB President Jean-Claude Trichet reiterated to BBC Radio his concern about rising inflation, and its structural impact on Europe's economy, saying that "price stability ... is the best way to have a high level of sustainable growth and sustainable job creation."

Trichet's intransigence

Despite the U.S. economic slump, which has slowed economic growth both in Europe and in other developed-world markets, the ECB, unlike the U.S. Federal Reserve, hasn't budged regarding short-term interest rates, and kept its key rate at 4%. The ECB has cited the threat to inflation posed by rising oil prices, among other factors, as the primary reason for its stand-pat policy.