US Treasury Secretary Henry Paulson's plan to end the rout in US financial markets may derail the dollar's three-month rally as investors weigh the costs of the rescue.



The combination of spending $US700 billion on soured mortgage- related assets and providing $US400 billion to guarantee money- market mutual funds will boost US borrowing as much as $US1 trillion, according to Barclays Capital interest-rate strategist Michael Pond in New York. While the rescue may restore investor confidence to battered financial markets, traders will again focus on the twin budget and current-account deficits and negative real US interest rates.



''As we get to the other side of this, the dollar will get crushed,'' said John Taylor, chairman of New York-based International Foreign Exchange Concepts, the world's biggest currency hedge-fund firm, which manages bout $US15 billion.



The dollar fell against the euro and 14 of the world's most- traded currencies on September 19 as Paulson unveiled the plan, even as the Standard & Poor's 500 Index rose 4%. The plan may end the rally that began in June and drove the US currency up 10% versus the euro, 2% against the yen and almost 13% compared with Brazil's real, strategists said.



Paulson's plan, sent to Congress September 20, would mark an unprecedented government intrusion into markets and increase the nation's debt ceiling by 6.6% to $US11.315 trillion. Officials may also start a $US400 billion Federal Deposit Insurance pool to insure investors in money-market funds.



Dollar 'Downdraft'



''The downdraft on the dollar from the hit to the balance sheet of the US government will dwarf the short-term gains from solving the banking crisis,'' said David Woo, London-based global head of foreign-exchange strategy at Barclays, the third-biggest currency trader, according to a 2008 survey by Euromoney Institutional Investor.



Paulson and Federal Reserve Chairman Ben S. Bernanke began plotting the rescue last week after New York-based Lehman Brothers filed for bankruptcy, the government seized control of American International Group and Merrill Lynch was forced into the arms of Bank of America.



Morgan Stanley dropped as much as 44% Sept. 17, the biggest one-day decline in its history, and Goldman Sachs, where Paulson was chief executive officer from 1998 to 2006, lost 26%. Both are based in New York.



In the four days following Lehman's bankruptcy, the ICE future exchange's Dollar Index, which measures the currency's performance against the US's six biggest trading partners, dropped 1.2%, leaving it 1.3% higher this year.



Dollar Hegemony



The dollar fell 0.8% to $US1.4466 per euro on September 19, bringing the greenback's decline for the week to 1.7%. While it strengthened 1.9% to 107.45 yen, it was still down 0.5% on the week.



''After years of doubting the hegemonic status of the dollar, this proves it's still there,'' said Stephen Jen, London- based head of research at Morgan Stanley. ''But of course this situation is definitely not stable. The capital leaving the emerging markets is only going into the dollar and that's a powerful force. It's a very uncomfortable balance.''



By the end of the year, the euro will weaken to $US1.43 and the yen will trade at 108 to the dollar, according to analyst surveys by Bloomberg. The dollar will depreciate to 1.65 against the real, compared with 1.83 on September 19.



Growth, Deficits



Although the dollar may suffer short-term, at least one analyst says the US government's planned rescue will strengthen the currency before long. Paulson's proposals will return foreign-exchange markets to the trend of the past months, according to Adam Boyton, senior currency strategist at Frankfurt-based Deutsche Bank, the world's biggest currency- trading bank. Since the end of June, the Dollar Index has gained 7.2%.



''It's a positive plan that's ultimately good for the dollar,'' said New York-based Boyton. ''It reduces risk and volatility and gets the focus back on macroeconomic fundamentals, which suggest weakness throughout the rest of the globe next year, with returning strength in the US.''



The US economy may expand 1.5% next year, according to the median estimate of 80 analysts surveyed by Bloomberg. That compares with 1.1% for the euro-region and 1.15% for Japan, the world's second-largest economy.



The rescue comes as the US budget deficit and the current- account balance, the broadest measure of trade, grow. The Congressional Budget Office projects the spending shortfall will increase to $US438 billion next year from $US407 billion. The current account deficit is up from $US167.24 billion in December.



'Huge New Supply'



''Investors may start to worry about the amount of debt the US is taking on and its impact on the dollar,'' said Geoffrey Yu, a currency strategist in London at UBS, the second-largest foreign-exchange trader. ''The fact that they mentioned taxpayer money implies that they're going to issue debt. If there's going to be a huge new supply of Treasuries, this will be dollar negative. It's too much for the dollar to take.''



Traders are also concerned the bank bailout will spread to other US industries suffering from the credit crunch that's holding back an economy growing at its slowest pace since 2001. Detroit-based General Motors, the world's biggest automaker, said last week it will tap the remaining $US3.5 billion of a $US4.5 billion credit line to pay for restructuring costs.



Lower interest rates may also weigh on the dollar. Futures on the Chicago Board of Trade show there's a 38% chance policy makers will lower their target rate for overnight lending between banks to at least 1.75% by January from 2% currently. A month ago, they showed a 46% chance of an increase to 2.25%.



'Damaged' Currencies



Rates in the US are already the lowest of any Group of 10 industrialized nations except Japan, where it's 0.5%. The European Central Bank's benchmark is 4.25%.



Another drawback for the dollar is that the Fed's key rate is 3.4% percentage points less than the rate of inflation, the most since 1980, so investors lose money by investing in short- term US fixed-income assets.



''People thought that the Fed was done cutting,'' said Andrew Balls, an executive vice president and member of the investment committee of Newport, California-based Pacific Investment Management, which oversees almost $US830 billion. ''In the longer term the diversification away from the dollar will remain intact. The US hasn't done itself any favors in making its assets attractive to foreign investors.''



The biggest beneficiaries may be Brazil's real and Australia's dollar, as demand for higher-yielding assets rebounds, according to Goldman Sachs. The two currencies, the biggest losers versus the dollar since July, may rebound 7.7% and 4.6%, respectively, the next two weeks, Goldman Sachs forecasts.



''The currencies that have been damaged the most have the best growth,'' said Jens Nordvig, a strategist with Goldman Sachs in New York. ''You're going to see a lot of flows back into these currencies now.''

Bloomberg

