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The downtrodden U.S.-dollar has staged a powerful rally during the past four weeks, but consensus is that it will continue to trend down in 2010, as it has for about eight years now.

A familiar litany of factors is driving the dollar down. It's a litany that includes the low interest rate policy of the U.S. Federal Reserve Board, a debt-burdened government that will need to raise taxes and put additional weight on the beleaguered consumer and inflation fears that continue unabated as the presses work overtime printing greenbacks.

The greenback has fallen 35 per cent since early 2002 against a basket of six major world currencies. It had a sharp rally in 2008 and early 2009 during the credit crisis as investors fled to safety, but had given up most of those gains before its recent surge of almost 5 per cent.

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(The average cyclical advance for the past 12 bear market U.S.-dollar rallies during a 40-year span is 10.6 per cent with a duration of about five months, according to a report by Martin Roberge, portfolio strategist and quantitative analyst with Dundee Securities Corp.)

The flip side of the coin is that while investors were dumping the dollar, they were buying the currencies and debt of other countries along with commodities in what is called the risk trade.

All major currencies, with the exception of the Japanese yen, have risen this year against the U.S. dollar, but the strongest performers have been the higher-yielding currencies (high-yielding government bonds), such as the Brazilian real, South African rand and the Australian and New Zealand dollars. The Brazilian real is up 43 per cent; the rand 36 per cent; the Australian dollar 30 per cent; and the New Zealand dollar 25.6 per cent. The Canadian dollar rose 17 per cent.

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"If there is a sell-off in risk assets, then we can expect these currencies to be hit hard," said David Bloom, global head of foreign exchange research with HSBC Holdings PLC.

Overall, HSBC expects the U.S. dollar will remain weak, especially against commodity-linked and emerging market currencies.

Is there a dollar bull story with legs?

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For now markets are convinced that the Fed is not about to begin raising interest rates any time soon, although once hikes are contemplated, that could prove to be positive for the dollar. The interest rate outlook could change sharply if there was a sense that the U.S. economy was about to stage a robust recovery.

Others think that it is a weak economy, not a robust one, that could lead to a higher dollar. "The biggest risk, in our view, is the market starts to worry about a double dip, where the bounce in activity gives way to renewed weakness in 2010," Mr. Bloom said. That would be negative for risk assets, resulting in a sell-off and, at least in the short term, it would be positive for the dollar, he said.

That's not a particularly strong, bullish case for the greenback. But, just maybe, the U.S. dollar sell-off is simply overdone.

During the past month, the U.S. dollar has started to muscle its way higher. The yen, the euro and Australian dollar have declined, respectively, 2.8 per cent, 4.1 per cent and 4.4 per cent against the greenback.

"The U.S. dollar is set to stage a narrowly focused recovery in 2010, in our view, strengthening against most G10 currencies, but continuing its weakening trend against many major emerging market currencies," said Steven Pearson, a foreign exchange strategist with Merrill Lynch & Co. Inc.

Merrill Lynch estimates the G10 currencies are on average 5.6 per cent overvalued against the greenback, while the currencies of the emerging markets are as much as 10.4 per cent undervalued. It expects the greenback will rise against the euro.

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High-yielding currencies

Look for commodity-linked countries with high interest rates on government bonds to continue to do well. Those currencies include the Australian dollar, the New Zealand dollar and the Norwegian krone, according to TD Securities Inc. On the other end of the scale, the U.S. dollar, the Japanese yen and the British pound should be relative underperformers.

The Canadian dollar v. the euro

The loonie, because of its commodity links, should significantly outperform the euro during 2010. The loonie will also be bolstered by the financial health of the government and the domestic economy's links with a recovering U.S. economy, say strategists with Merrill Lynch and TD Securities.

The Canadian dollar v. the greenback

The Canadian dollar should outperform the U.S. dollar - reaching parity with the greenback - because of its exposure to commodities, its attractiveness to international investors (because it holds little sovereign risk), the strong domestic economy and the banking system, said Scotia Capital Inc. The loonie will also have the advantage of benefiting from a recovering U.S. economy.

The British pound

Britain's pound is likely to remain weak against most of the major currencies for much of the year as it recovers from the recession and the government is burdened with a heavy debt load, according to TD Securities.

The Japanese yen v. the U.S. dollar

This is a trade in which there is a sharp divergence of views.

The yen is expected to remain strong as domestic capital stays at home and its current account surplus rebuilds. The Japanese economy "is the most unloved of all major equity markets," Merrill Lynch strategists said. That leaves open the possibility of a change in sentiment and increased demand for the yen.

The opposing view is that the yen has soared in value despite the weak economy and further strengthening will not be tolerated by the Japanese authorities, so the yen could ease modestly against the U.S. dollar, TD Securities said.

The Chinese yuan

China's currency, the renminbi or yuan, is significantly undervalued against the U.S. dollar and other free-floating securities, but it is pegged by the government to the greenback. "China will take its time in moving," according to the HSBC Holdings currency strategy group. "A currency move in 2010 still seems the most reasonable timing, but it is unlikely to be early in the year."

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