Yesterday, the dollar rallied hard against the euro. And today I want to tell you what I think is happening. Let’s start with a question …

What happened to decoupling, the idea that other economies were immune to weakness in the U.S.?

Well, it seems as though the subprime fiasco has created bigger problems for the U.S. financial system than most people anticipated. And now we’re seeing this economic virus spread across other areas of the globe.

If you want some evidence of contagion in other developed economies, look no further than these recent news items …

• German industrial orders dropped sharply — by 2.9% in June. What’s most disconcerting is that Germany’s economy makes up one-third of total Eurozone output. And speaking of the rest of the Eurozone, many of those economies are bogged down by housing busts.

• The International Monetary Fund (IMF) called out the U.K. economy. Predictions for economic growth in the UK for 2008 and 2009 stood at 1.8% and 1.7%, respectively. Kiss those numbers goodbye. The IMF’s latest forecast calls for a seriously lower 1.4% in 2008 and 1.1% in 2009.

• Australia is battling sluggish household spending and their financial sector is being challenged. The National Bank of Australia recently reported a huge second quarter write down which it attributed to massive holdings of CDOs.

• And the New Zealand Treasury anticipates a second consecutive quarter of negative GDP growth. By definition, New Zealand will have entered recession once official numbers are released. They’d be the second OECD-member country since Denmark to sink to official recessionary status.

The reality is that the big three in the developed world — the U.S. the U.K., and the Eurozone — are staring into the face of recession.

And China May Have Some
Issues to Sort Through, Too …

As we were so often told when the decoupling theory gained traction, China is set to take over the world.

But if weakness is spreading around the globe, what does that mean for China?

The 2008 Summer Olympics are just now beginning, and there’s news that pollution has grown to far worse levels over the last few months. Chinese officials are putting all kinds of limits on the number of cars that can be on the road on any given day.

Additionally, in an effort to minimize excessive air pollution, Beijing is closing 105 factories. And should conditions worsen, neighboring cities could close as many as 117 factories combined.

Anticipation of the games gave Chinese companies reason to ramp up production. But what’s worrisome is that these companies front-loaded production and an inventory glut is building up.

It makes you wonder how much extra production was jammed into the last quarter in order to prepare for air cleansing before the great games began.

I suspect plenty.

That’s never good because growth will be sacrificed for as long as it takes to work through the oversupply.

For All These Reasons, We Should Revisit
The Commodities-Currencies Connection

If the global economy is slowing, and China is forced to work through excess inventory, demand for commodities will be impacted. My bet is that crude oil prices, in particular, will suffer from the realities I just described.

And remember, commodity prices and currencies influence each other in a self-feeding circle.

For example, falling crude prices may be the one force that allows central banks in the U.K. and Europe to begin lowering their interest rates.

If and when that occurs, the dollar will become more attractive relative to those currencies.

It wouldn’t take a bold move on the part of the U.S. Federal Reserve, either. (Nor do I expect one.)

A narrowing interest rate disadvantage between the dollar and euro — or the dollar and the pound — would be hugely supportive for the greenback.

In fact, this may very well be why the dollar HAS ALREADY been holding up given such incredibly dismal news day after day from the U.S. economy.

Take a look at this chart …

Over the last year or so almost everyone’s been pointing to the inverse relationship between the U.S. dollar and crude oil.

At the very left of the red rectangle on my chart, you can see where the tight inverse correlation began to break down. That’s when the dollar bounced higher from its all-time low. Crude soared well beyond its record high at the same time.

Crude rallying and the dollar drifting slowly higher simultaneously? That was certainly no inverse correlation.

But from the furthest right point of that red box is where the tight inverse correlation has resumed. Only this time, the direction is in favor of the dollar. And it comes exactly after a new all-time high for crude prices.

Translation: The buck could be back.

The dollar has been able to continue its rally this week, even amidst a blitzkrieg of central bank announcements. While it has a long way to go — and recovery may not be swift — I think it’s time to keep the dollar rally scenarios in clear sight. Especially now that other economies are catching the bug.

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