The dollar's perfect storm worsens

That's left the European Central Bank worriedly watching a developing credit crunch on its turf that mirrors the one in the United States. The bank has repeatedly intervened, most strongly in August, to inject cash into the financial markets. On Aug. 9, 10 and 13, the bank injected $130 billion, $84 billion and $65 billion, respectively, into the financial markets.

With the debt markets still in the grip of a crisis that has dried up lending among banks and sent almost all buyers of short-term commercial paper backed by mortgages, credit cards and car loans scurrying for safety, the European Central Bank doesn't want to do anything -- such as raising interest rates -- that might make the crisis worse.

The bank's 19-member governing board has made it clear in recent public statements that it's undecided about what to do. Portugal's Vitor Constancio last week called the jump in inflation "temporary" and said there are no signs that higher energy costs are working their way into higher wages or other prices. A day later, Austria's Klaus Liebscher said inflation risks are "clearly on the upside."

• Discuss with Jim Jubak: Will Europe kick the dollar while it's down?

From what I can tell, the majority of the bank's board comes down on Liebscher's side. I don't think the bank wants to run the risk of jeopardizing its inflation-fighting credentials even at this juncture. The most likely outcome Thursday is a 0.25-percentage-point increase in short-term rates balanced by continued injections of cash into the financial markets. And there's almost no chance that the bank will cut interest rates with inflation warning signs flashing so brightly.

Why the interest-rate gap matters

That puts the U.S. Federal Reserve, which holds its own Open Market Committee meeting on short-term rates just a few days later, on Dec. 11, in a quandary. If the Fed cuts interest rates as Wall Street expects -- right now the odds of a rate cut are about 90%, according to the federal funds futures market -- and the European Central Bank raises rates, that will eliminate the interest-rate gap between the United States and the European Union. Short-term rates in both markets would stand at 4.25%. If the Fed eases to 4.25% and the European Central Bank stands pat, the gap will shrink from the current half-point to a meager quarter-point.

And the euro, which has been climbing steadily against the U.S. dollar for most of 2007, will climb even more. Shrinking or closing the interest-rate gap between the two currencies will eliminate one more reason for the world to hold dollars.

I'll admit I don't know what the two banks will decide Thursday and Dec. 11. But I do know what will happen if the interest-rate gap between the two currencies shrinks further:

• The U.S. dollar will fall, and the euro will climb.

• The price of oil, which trades in U.S. dollars, will go up again, as oil producers adjust prices so that they at least break even on the dollar's decline.

• Gold prices will climb as investors seek an alternative to the U.S. dollar as well as safety from uncertainty about the global economy and a likely bump in U.S. inflation.

• U.S. equities will rally in the days after a Federal Reserve rate cut but then give much of the gains back as overseas investors pull money out of the U.S. financial markets in response to the dollar's weakness.

So, as an investor, what do you do? I outlined five steps in my Nov. 13 column, "5 ways to ride out the market's storm." I've implemented a couple of those suggestions by buying land stocks with dividends ("Land ho! Now's the time to buy") and natural-resource stocks ("Make money off China's nightmare") since that column.

In my next column, I'm going to take a look at what strikes me as the most promising way to make money from the weakness of the U.S. dollar: buying shares in midsize or smaller U.S. exporters that will sell more as a weaker dollar makes their products cheaper to overseas buyers. I'll end that column with five stocks that fit the bill.

Continued: Developments on a past column

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