The dollar is definitely breaking out of its long slump. The Dollar Index on the ICE futures exchange, which tracks the dollar against the currencies of six US trading partners, reached its highest level today since February 26. Traders are looking for a reason to sell the euro says Chris Gaffney in The Daily Reckoning. But do the fundamentals support the dollar bulls? More from Chris below…

The dollar started its big move just after the Trichet gave his statement on his views of the European economy. The ECB left rates unchanged, but Trichet said economic growth will be ‘particularly weak’ through the third quarter, suggesting policy makers will be wary of raising interest rates again to curb inflation. While the ECB’s decision to raise borrowing costs last month was justified by the inflation threat, risks to growth ‘are materializing,’ Trichet told reporters. ‘Overall, downside risks prevail.’

These somewhat dovish words by the ECB President send the euro down a cent and 1/2. Currency traders had been pricing in another interest rate increase by the ECB before year end, but now they have abruptly changed their bets and are thinking the ECB’s next move will be a cut in interest rates. This flies in the face of the inflationary reports we got out of Europe yesterday, but the markets

[...] The currency market starts looking for a reason to move one way, and no matter what the data look like, they spin it to fit the direction they want the currencies to move. Earlier this year, traders were looking for a reason to sell the dollar, now they are looking for reasons to buy it. But have the fundamentals changed? Is the US economy any stronger now than it was a few months ago?

Nope. Numbers released yesterday show US consumers borrowed more than twice as much as economists forecast in June as a decline in home equity forced Americans to fund purchases with credit cards and other loans. Consumer credit rose by $14.3 billion, the most since November, to $2.59 trillion. Consumers here in the US are using credit cards and loans to cover expenses as falling home values cause banks to restrict access to home-equity lines.

And the weekly jobless claims released yesterday showed another 455,000 workers filed last week, 30,000 more than economists predicted. Continuing claims also rose to 3,311,000. The only positive piece of data released in the US yesterday showed pending sales of previously owned homes rose in June as buyers swept up foreclosed properties. But I don’t think you can look at an increase in foreclosure sales as a real positive for the US economy.

No, the underlying economic fundamentals of the US economy have not improved. In fact, they have actually worsened. Last week I reported how the administration is projecting a record high deficit in 2009. The 2008 fiscal deficit forecast of $289 billion equals 2.7% of GDP, while the 2009 fiscal deficit estimate of $482 billion is equivalent to 3.3% of GDP based on a 2.2% GDP growth projection for 2009. And if you take the IMF’s projection of only .8% US GDP growth instead of the administrations overly optimistic 2.2% GDP rate, the fiscal deficit would stand at 3.5% of GDP, matching the 2004 high.

The administration have also predicted a declining current account deficit to 4.9% and 4.7% of GDP in 2008 and 2009 respectively. This puts the total of these twin deficits (budget and current account) to near 8.0% of GDP in 2009. Implications of these twin deficits are significant for the US$, as foreign investors face an even wider choice of alternatives to US dollar investments. The credit crisis in the US has already made foreigners a little wary of US investments and higher US interest rates would be required to maintain foreign flows into the US. But higher rates will mean a further drag on a faltering US economy. I continue to believe that these twin deficits, and weak underlying economic fundamentals will push the dollar lower over the longer term.

But the currency traders have a shorter outlook, and their current interest rate expectations have caused them to push the dollar higher. Even long time Euro bull Bill Gross, who manages the world’s biggest bond fund, is sounding more like a dollar bull. “The economy in euro land is not sinking, but it’s moving closer to the zero line than one would have expected only several weeks ago,” Goss said yesterday on Bloomberg TV. The ECB has “got to factor in the economy. I would expect at some point in the next six to 12 months for the ECB to even lower interest rates. The recession in the US has been factored in and the weakness in the euro land is just beginning to be factored in,” Gross said.

Yes, the markets are all talking about the ECB lowering rates and once the euro moved through major support at $1.53, the technical traders took it down to below $1.51. And the dollar didn’t just rally vs. the European currencies, it gained vs. the Asian and commodity based currencies also. Even the Brazilian real, the recent darling of the currency markets, fell for a fourth day as traders moved funds back into the US$.

PS: Read on here for more on whether the current dollar rally has legs.

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