The dollar has taken a break from its recent climb. It fell 0.5% against the euro this morning in European trade. 

Nevertheless, dollar strength is big news these days. Could the US downturn be bottoming just as Europe falls into recession?

Dan Denning in The Daily Reckoning Australia is not so sure. What’s strange about the dollar rally, says Dan, is that it’s taking place as America’s fiscal position deteriorates. How can a currency rise when its foundation continues to crumble?

Doug Noland at the Credit Bubble Bulletin reports that the U.S. government racked up a US$102.8 billion deficit in July. Deficits are nothing new for the American government. But the alarming evidence is that spending is up (27% year over year) while tax receipts are down (5.8%). More on this in a moment.

To wax historical for just a moment, the U.S. dollar’s breakout reminds us of the German offensive in the Ardennes in December of 1944. The Germans were slowly being hemmed in all over Europe by late 1944. The last thing the Allies expected was an attack. Hitler ordered one though, sending Panzer divisions through the Ardennes (as he did in 1940).

It nearly worked. The attack caught the Allies by surprise and forced the Americans to rush the 101st Airborne into the French town of Bastogne to hold out until they could be resupplied and reinforced. Hold out they did. Eventually, the German advance was repelled. But it shocked everyone in the Allied command that an opponent so clearly on the strategic ropes could come so close to reversing the momentum of events.

There are at least four reasons we can think of that explain the U.S. dollar’s resurgence (although none of them suggest permanent new strength). The first: the short-dollar trade is being covered. A lot of institutions were short the dollar. The suddenness and swiftness and simultaneity of the short covering explains the explosiveness of the rally (and the similar carnage in commodity prices).

Second, there’s an emerging trading thesis that as Europe and Japan post negative second quarter growth, America’s economy will bottom out before the rest of the world, making the dollar and U.S. stocks and bonds better investments.

This thesis is that all the world is a recession, but America is closer to exiting it. It’s not our favourite explanation. But it’s possible someone believes it and is trading on it.

A third and likelier explanation is that official money supply around the world has ceased growing as quickly. Global M2 growth is notoriously hard to compile and track. But with banks distrusting one another, the contraction in global credit is showing up in lower prices for nearly everything. It’s financial asset deflation on a global scale, in all markets and all asset classes.

Finally, there is the possibility that foreign central banks are selling their own currencies and buying dollars. It’s a case of competitive devaluations designed to increase exports to the U.S. and out-inflate the Fed. It also goes by the name of currency manipulation.

Are any of them true? Are all of them true? We reckon that the prospect of global recession is boosting the dollar. The short-covering and deleveraging by speculators is another big factor. Markets move in cycles, too.

But in the scheme of things… we’d continue to view this dollar rally with deep distrust. Changing attitudes currently support the dollar.

But the facts underlying the currency don’t support it one bit. That to us is the best reason to sift through the rubble of the resource market for shares that will excel during the next phase of this battle Royale between paper currencies and real assets. More on hyperinflation (and whether we’ve already had it) tomorrow.