Since 2002, the Dollar has lost 70% of its value, relative to the Euro.  Meanwhile, the same factors that signaled bearishness in 2002 persist in 2008, or even worsened in some aspects.  The twin deficits are still growing, though the current account deficit may be leveling off.  The US economy is headed towards recession.  Inflation is set to rise due to soaring commodity prices and a loosening of monetary policy.  As a result, many investors are betting that the Dollar's slide will continue well into the near future.

However, prudent investors would be wise to "handle with care." While not entirely applicable to forex markets, efficient markets theory dictates that inherent in a security's current valuation is all relevant, publicly available information. Thus, all of the bad news listed above has already been priced into the Dollar, to some degree at least. The rule of diversification is in full effect when betting on forex. Thus, rather then putting all of one's chips directly behind one currency, an investors could buy foreign securities (stocks and bonds) instead, which also capture any currency appreciation (and depreciation).  Investors can also purchase Treasury Inflation Protected Securities (TIPS), whose yield is linked to inflation and, thus, acts as a hedge against a declining Dollar. The Wall Street Journal reports:

While some market watchers believe the six-year dollar bear market isn't over yet, investors should recognize that trends in the currency markets are typically marked by volatile ups and downs along the way.

Read More: Don't Bet the Farm on Dollar's Skid

In a recent article published in the Toronto Star, a Canadian columnist outlined five reasons why the Canadian economy is in trouble.  Only a couple factors are unique to Canada, and several can be subsumed under the credit crunch, but the pessimists are sounding broad alarm bells. First on the list is the looming drop in prices for commodities, the cornerstone of Canada's economy. Oil recently sank below $100/barrel, and gold dropped 5% in one day! In addition, China is threatening to curb demand in order to rein in inflation. 

The second and third causes for concern are a decline in bank credit and loss of confidence, respectively. Neither of these factors are endemic to Canada, as banks around the world have suddenly developed an aversion to risk and have tightened lending accordingly. Next, corporate expansion (namely of American companies) is stalling; Home Depot and Proctor & Gamble have already announced a temporary hold on opening new stores in Canada.  The final factor(s) are American consumers, which collectively spend $9 Trillion per year.  The recent tightening of wallets could spell massive trouble for Canada, since some of its provincial economies are primarily driven by cross-border sales to Americans.

In short, the Canadian economy could actually contract in 2008.  But perhaps the resulting decline in Canada's currency, the loonie, would make Canadian exports comparatively more attractive and return the economy to firm footing in 2009.

Read More: 5 reasons to start worrying

Two American economists recently conducted a computer simulation to determine how the role of the US Dollar as the world's reserve currency will evolve over the next decade.  Their hypothesis- that the Dollar's preeminence would be maintained- was contradicted by the simulation leading them to conclude that the Euro will overtake the Dollar within the next 10-15 years. This may be hard for many analysts to stomach, since the Dollar's share in global currency reserves is 66%, compared to the Euro's 25%. In addition, the Dollar has held its title for nearly 150 years, and it's difficult to fathom its being replaced.

However, two factors have emerged within the last 10 years, lending support to the argument.  First, the US twin deficits have exploded; the current account deficit approximates $800 Billion and the national debt is estimated at $9.4 Trillion. Second, prior to the inception of the Euro, there didn't exist a credible alternative to the Dollar. The Deutsch Mark and Japanese Yen initially seemed like potential candidates, but the German currency was folded into the Euro, and the Japanese economy has soured and taken over by deflation. Then there are peripheral factors, like US monetary policy, which is facilitating inflation and eroding the Dollar.  There are also signs that a neo-imperialist foreign policy has overstretched the US, and foreign Central Banks are becoming nervous.  The Financial Times reports:

Many developing countries will find it harder to maintain their dollar pegs. They may be reluctant to drop them now but there will come a point when the rise in inflationary pressures becomes unbearable.

Read More: This crisis could bring the euro centre-stage

As U.S. stocks rallied, with investors willing to take on more risk, the dollar recouped some of Monday's sharp losses versus the low-yielding yen.

Yesterday, the Forex Blog reported that the risk of intervention in forex markets is growing, in order to prop up an ailing Dollar.  The focus of the post was on the Euro, which is hovering below the record high of $1.60 reached last week. With this post, we wish to extend coverage of the potential intervention to include Japan.  In some respects, Japan is actually a more likely candidate for intervention, since it has a history of actively depressing its currency.  Most recently, in 2004, it accumulated $350 Billion in Dollar-denominated assets in a large scale effort to keep the Yen from rising out of control. 

Japan's consumers are notoriously tightfisted, and consequently, its economy is dependent on the export sector to drive growth. Unfortunately, the more expensive Yen is making this sector less competitive. In addition, Japan's new Prime Minister has yet to lay out an economic plan, and the stock market is foundering. A number of creative solutions are being mulled, including one to buy American mortgage-backed securities, in order to head off the international opposition to intervention. The New York Times reports:

That might win Washington’s approval by helping to ease the credit squeeze in the United States, but given such securities’ role in precipitating the crisis of the last several months, it might well set off cries of dismay here.

Read More: As Dollar Keeps Falling, Talk of a Move by Japan

Last week, the Euro retreated from the record high of $1.60 that it achieved earlier in the week. Policymakers are still concerned, however, and are perhaps using this lull to come up with a plan of action should the Dollar resume its slide. In fact, the consensus among analysts is that coordinated intervention is likely if the Euro crosses a certain threshold- perhaps $1.65. In order to be successful, the intervention would need to involve the Federal Reserve Bank and the European Central Bank principally, as well as the peripheral participation of the Central Banks of Switzerland, Japan and England.  The situation is complicated by the monetary policy of the ECB, the tightness of which is causing the interest rate differential with the US to widen dramatically. Already, volatility levels in forex markets are slowly climbing, suggesting that investors are bracing themselves for a big move.  The Guardian UK reports:

ECB Executive Board member Lorenzo Bini Smaghi said in a speech on Tuesday markets sometimes overshot, with possible negative implications for the world economy. Since his speech, the dollar has strengthened by almost 2 cents against the euro.

Read More: Euro intervention edging nearer, but still distant

In a thinly disguised effort to stem the appreciation of its currency, Brazil has announced sweeping changes to its rules governing forex.  Rather than revert to outright intervention in the forex markets, however, Brazil will permit businesses to hold more foreign currency as part of their reserves.  In this way, the Central Bank won't have to purchase Dollar-denominated assets directly.  Instead, it is hoping that the natural attraction of US and other Western capital markets will be enough to drive private Brazilian companies to increase their holdings abroad.  It is intended that this will act against the upward pressure on the Real, which rose 20% against the Dollar in 2007, and 5% already in 2008, and now threatens to drag down the economy.  Dow Jones reports:

The strong real has made some Brazilian manufactured exports such as textiles and footwear less competitive. Meanwhile, it also has introduced a boom in imports resulting in a narrowing of the country's trade surplus.

Read More: Brazil Council To Meet Wed To Change Forex Rules

In a recent commentary piece, the Market Oracle used the analogy of baseball to outline why this will be an "off year" for the Dollar, listing three reasons to support its claim. Consumer spending was listed first because it represents the largest component of US GDP.  Since much consumption is financed through borrowing and since the credit crunch has forced banks to rein in lending, the Oracle reasoned that consumer spending will be especially hard hit. Next, there is the worsening employment picture. As its moniker implies, the "jobless recovery" that has characterized the US economy over the last few years did not add many jobs, and due to the economic downturn, jobs are now being shed.  Finally, the Market Oracle has identified the Federal Reserve as a primary contributor to the decline of the Dollar. While the Fed is trying to shore up the economy, it is simultaneously enabling inflation.  Thus, even if the battle is won and recession is averted, the Fed may still find that it has lost the war- on prices.

Read More: Three Strikes Against the U.S. Dollar

"I'm disappointed," said an economist at Citigroup. "It's not as if we're trying to gauge policy priorities on a sunny day. I'd like to know how you're going to get inflation in an environment with suffocating financial restraint and pervasive slowing in demand."

Ironically, the faltering US economy has induced the Dollar to appreciate against many of the world's currencies. The reasoning is that countries whose economies are tied closely to the US will falter even more than the US during a recession. One of those countries is apparently Canada. As a result, the Bank of Canada has already moved to cut rates by 50 basis points in order to mitigate against a full-blown Canadian recession. All of the economic indicators are already pointing downwards and GDP growth is projected to be a paltry 1.8% in 2008.  In addition, exports to Canada's largest trade partner, the US, have sagged noticeably, such that its current account recently slipped into deficit for the first time in nearly a decade. The Bank of Canada is busy plotting strategy, with additional rate cuts in the offing.  It looks like the monumental run of the Loonie has finally come to an end.  Bloomberg News reports:

Canada's dollar will probably remain within the range it has held since the start of the year because investors are still avoiding risk amid the unsettled U.S. economic outlook. It has traded within about 4 percent of parity with its U.S. counterpart, after surging last year as high as 17 percent.

Read More: Canadian Dollar Falls on Speculation More Rate Cuts Are Coming