The dollar climbed against the Euro this week, but that climb may be very short lived.  Leading central banks around the world are attempting to ease the shortage of dollars in the global money market during this last fiscal quarter of 2008, and if they are successful the dollars gains may very quickly unwind.  Dollar assets in European banks are feeling the economic crisis as badly as the assets held by American banks, thanks to the mortgage crisis which set the snowball rolling.

Investors have been shifting their routine and are starting to go for ‘safe-haven’ investments which have made a mess out of the economic landscape and difficult for strategists to come up with any long-term foreign exchange prediction – fallout or otherwise.  But when analysts take a look at European banks’ balance sheets and liability management records for the end of 2008’s third quarter, they are discovering a very revealing pattern across the board.  “The big problem in the banking system is a shortage of dollars — so when funding issues get tight, the dollar goes up, and when they ease, the dollar retreats,” said Joe Prendergast, Currency Investment Advisor at Credit Suisse in Zurich.

The third quarter came to a close on Tuesday, and the dollar racked up its biggest one day gain since the Euro was launched in 1999.  The move happened thanks to the European banking system realizing just how exposed they were to problems and recognizing that interest rates would need to drop quickly soon.  They also know that the US government is in the process of developing a comprehensive solution.

Analysts are arguing over whether or not the surge was due to the fact that there is a severe shortage of American dollars in Europe which has led to freezing interbank lending, banks having sudden liquidity problems, and a doubling of the swap line for the dollar.  Borrowing rates soared of the Fed’s 2% overnight and the dollar recouped the 5% it had lost to the Euro when Lehman Brothers filed for bankruptcy.

“If people can’t fund themselves through the money market or swaps, they have to go out and buy dollars. That’s what we’ve descended into,” said Gerrard Katz, the head of North Asia currency trading at Standard Chartered in Hong Kong.  Official dollar rates were more than three points lower than the European Central Banks’ and the rates almost halved to 3.79% since the end of the third quarter and the beginning of the fourth.

There is no way of knowing how long this raw flow of money will influence the exchange rate or for how long.  “Central action to provide large scale dollar liquidity may help markets, but takes away one important source of dollar support as the dollar funding squeeze eases,” said Prendergast at Credit Suisse. “We recommend investors consider using current levels to position for a return of significant dollar weakness.”