Why the dollar's bounce doesn't mean it's back

By Jia Lynn Yang, Fortune reporter

(FORTUNE Magazine) -- The greenback has been sliding against foreign currencies for most of the past five years, but it started strong in 2007. That may not last.

1 How much has the dollar really rallied? Not that much. In the first two weeks of January, the value of the dollar increased 2% vs. the euro. And it's near a four-year high against the faltering yen. But since hitting a peak in 2002, the greenback has fallen 29% against a basket of six major currencies and 50% against the euro alone.

2 What's driving it up now? Two words: interest rates. Recent U.S. economic reports show surprisingly robust consumer spending and accelerating industrial activity. That means Fed chairman Ben Bernanke is likely to hold the benchmark rate at 5.25% to keep inflation in check. Investors who've been anticipating a cut (and looking for currencies where the interest rate, and thus their returns, might rise) are moving back into dollars.

3 What could send it back down? The same thing that's been weighing on it for years: the rising U.S. current account deficit (the trade deficit plus interest payments), which hit $900 billion, some 7% of GDP, in 2006. Historically, ratios above 5% of GDP have caused currencies to lose value.

4 How can I hedge? Make sure a portion of your portfolio is in international stocks or bonds, preferably of companies that aren't reliant on the U.S. economy. For a purer play against the dollar, you can open a savings account or buy a CD in a foreign currency.

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