Could next year be the year of the dollar?

We all know why the dollar is in the cellar right now. We also know why it's expected to continue right through to the basement floor:

Massive budget and trade deficits.

Ultra-low interest rates. (Zero on the short end.)

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$59 trillion in unfunded liabilities for Social Security, Medicare and Medicaid.

Bernanke conjuring extra trillions out of thin air to buy Treasuries and mortgage-back securities and patch various holes in the US economy.

There is no reason to believe any of these problems will vanish in the months ahead. Yet the dollar will soar in 2010. Here's why...

Two reasons for a dollar rebound

There are two main forces that could drive the dollar higher:

All the problems mentioned above are already well recognised and priced into the greenback.

Dollar psychology is overwhelmingly bearish. Just as ten years ago, investors couldn't imagine internet stocks doing anything but soaring higher. Five years ago, they couldn't imagine real estate doing anything but barrelling down the same one-way street. Record lows for the dollar are coinciding with enormous confidence that the dollar has nowhere to go but down.

When extreme valuations are accompanied by unbridled optimism or abject pessimism, it virtually always marks a turning point - and an opportunity. This is no exception.

Commentators seem to forget that all currency values are contingent. You can't just look at fundamentals in the United States. You have to look at them abroad, too.

And there isn't much out there right now that's terribly positive...

America's fellow heavyweights have problems, too

Take Europe, for example...

Eurozone: In the third quarter, the 16-nation Eurozone grew at a 1.5% annual rate. The US economy, by comparison, grew at 3.5%. European consumers and most business sectors are still feeling the pain from the deepest recession since the 1930s. The continent is likely to be the weakest region for global expansion next year, according to Julian Callow, Chief European Economist at Barclays Capital in London.

United Kingdom: This is no bastion of strength, either. Europe's biggest economy outside the Eurozone is still in recession, due to overly-indebted British households and tight credit. British GDP contracted at an annualised 1.6% in the third quarter.

Japan: The world's second-largest economy has its own problems, too. At 172% of GDP, Japan's government debt is by far the largest among rich nations. What's more, it's expected to reach 200% next year - and hit 300% within a decade. Rising social security costs and the weak economy are the primary culprits.

The new government there is trying to prevent a double-dip recession by spending even more. But with government debt soaring to records, talk of new stimulus measures is already pushing up long-term rates and threatening to curtail the impact of fresh spending.

Bet on the dollar in 2010

Recognise that Europe and Japan are hardly experiencing heady economic growth and great fiscal probity. Most are bogged down economically and running fiscal deficits as bad as ours.

And personally, when the whole world is in this big a mess, I'll take the greenback over the euro, the pound, or the yen. My bet is in 2010, so will most world currency investors.

Virtually no one is expecting it, but the dollar is likely to climb 20% against the euro and the pound next year and 15% against the yen.

Hedging is fine, of course. But if you have too much exposure to foreign-currency denominated bonds, CDs, or bank accounts, rein it in.

This article was written by Alexander Green for the free investment email Investment U