The world will learn to love the dollar again in 2014

The government is prone to occasional shut downs. The trade and budget deficits have been out of control for a decade. It botched the last couple of wars it fought and the central bank has spent the last five years printing more money than anyone even knew existed. There has been no shortage of reasons for the rest of the world to get out of the dollar over the past decade.

But in 2014 that is about to change, and decisively so. This will be the year the dollar DXY +0.06% comes roaring back.

Why? There are three reasons.

First, U.S. growth is going to be the fastest in the developed world, and faster even than in many emerging nations. Second, the Federal Reserve is going to at least slow the pace of quantitative easing, even if it does not get rid of it completely. Thirdly, there is a heightened risk of a geopolitical crisis somewhere in the world — and in a crisis investors always flee to the dollar.

The net result will be a big comeback for the American currency.

There is no shortage of evidence that the world has been steadily falling out of love with the dollar. In the first few years after it was launched in 1999, the euro EURUSD -0.05% gained significant traction as an alternative, taking a rising share of central-bank reserves.

But the crisis in the single currency meant it was no longer a serious alternative to anything.

Next, gold soared in value as investors looked for alternative stores of value, although gold has lost much of its appeal in the past year. In the last few months even bitcoin has flourished as an alternative — and yet as fascinating as the digital currency is, it is still too flaky to seriously rival traditional money.

It is not hard to understand why investors wanted to diversify out of dollars.

It cemented its position as the global reserve currency immediately after World War Two when the U.S. alone accounted for close on 80% of global gross national product. No matter how well the U.S. did, that share was always going to decline as the rest of the world recovered.

The U.S. added in quite a few problems of its own, however. A financial crisis, a central bank that cared little for the value of the currency, and a political system that to outsiders looks completely dysfunctional, all contributed to the currency’s decline. In the past year, even the euro has been strong against the dollar — even though it is hard to think of any compelling reason for buying Europe’s single currency.

This year, that is about to change. Here’s why.

First, the U.S. economy looks set to be the strongest in the developed world over the next 12 months. The surprises are all likely to be on the upside. The latest quarterly figures showed the U.S. growing at a healthy 4.1%.

Sure, you can dismiss that as good quarter that may not be sustained. Yet momentum is the most important force in economics and right now the momentum is with the U.S.

House prices are recovering sharply, but still have a long way to go. Employment is expanding, and if enough jobs can be created employers may even be forced to start raising wages — because they will have to compete for workers again. Personal debts are coming under control, creating scope for more consumer spending. It all points to that last quarterly number being a signal of a higher growth ahead, and not a mere blip.

Second, the Federal Reserve has started to taper. It remains to be seen whether it can sustain that. In Japan’s two-decade experiment with QE it has turned off the taps plenty of times only to quickly turn them back on again.

But over the next six months, with stronger growth figures coming through, the Fed is likely to keep scaling back the stimulus.

While the Fed is winding up QE, other central banks will be turning it up. The Bank of England may hold fire. But the Bank of Japan is likely to intensify its asset purchases, both to sustain the tepid recovery, and to mitigate the impact of a hike in sales tax. The European Central Bank could easily be forced finally to unleash QE to rescue a sinking French economy and a struggling periphery.

In that kind of company, incoming Fed chair Janet Yellen is going to look like Friedrich Hayek in her commitment to monetary discipline. Currency markets hate QE — so that too bodes well for the dollar.

Finally, there is a heightened risk of a geopolitical crisis. Several flashpoints look very hot.

There is tension between China and Japan, traditional adversaries for control of East Asia. North Korea could well be on the brink of a messy implosion. The Syrian civil war rages on, and could spill over its borders at any moment. Turkey has been rocked by a second political crisis in the space of less than a year — a third one could be fatal to the existing government.

No one knows when any of those simmering conflicts might erupt into a full-scale war. But we do know for certain that it only takes the threat of a major geopolitical crisis to send investors fleeing back to the safety of the dollar.

None of that necessarily makes much difference to U.S. investors. The American markets already look more than fairly valued. But to investors from the rest of the world, U.S. equities, and even bonds, still look attractive, simply because they are likely to gain on the rise on the currency, even if the indexes don’t end the year much higher. The U.S. market was driven by domestic buying in 2013 — in 2014 it will be foreign buying that drives it higher.

True, the American currency is still in long-term decline as the world’s reserve currency. A few good months won’t change that: the U.S. share of global output gets relentless smaller every year.

But that does not mean it cannot stage bear-market rallies. This year is set to be one of them.