How the dollar rout could turn ugly by Colin Barr @FortuneMagazine April 28, 2011, 3:17 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Memo to Bill Gross: You’ve got the right idea but the wrong trade. That’s the implication of a note out this week from Bank of America Merrill Lynch. It advises clients that the way to make money on rampant U.S. fiscal stupidity is to bet against the swooning dollar — not on a massive selloff in government bonds, a la Gross’ Pimco Total Return fund. Not more of this? Rates strategist David Woo says that even with the dollar index trading at a three-year low and the euro creeping up on $1.50 – a level also last seen in that banner year of 2008 – there are signs that markets are underestimating the risk that the dollar could swing sharply lower in coming months. He says the theater of the absurd playing out in Washington makes it likelier that investors will dump the dollar as it becomes apparent that progress on a fix to our national spending addiction is not in train. In our risk scenario, little progress on the fiscal front raises the probability of a fiscal crisis and the odds that the Fed becomes the buyer of the last resort. This would accelerate the process of the USD’s demise as the global reserve currency and cause it to decline in a disorderly manner. This is not what Woo expects to happen, mind you. He believes Tim Geithner when he says Republicans and Democrats will patch over their many differences long enough to raise the debt ceiling before the government goes splat in July, and perhaps to agree on some sort of plan to impose on Congress at least the spending discipline of drunken sailors. Accordingly, he forecasts that the dollar will bounce back against the euro, whose users have problems of their own, and rise to $1.30 against the euro by midyear. But the sound of political gunfire being exchanged daily is not reassuring to markets, which Woo warns will eventually catch on to the full horror of the U.S. budget position. While economists at Goldman and elsewhere keep assuring us that a weak private sector recovery is gaining steam, Woo notes that it “has been so dependent on expansionary fiscal policy that as much as half of the $850bn increase in annualized US household disposable income since the end of 2008 was due to increased net social benefits to households.” Over the past decade, he notes, the share of household income coming from net social benefits – the difference between government payouts on things like welfare, food stamps, unemployment insurance and healthcare, and the amount taxpayers pay into those programs – has more than doubled to a recent 12%. That is by far the highest number in the past 40 years. Meanwhile, the United States is the only major nation that hasn’t recently been hit by a massive earthquake and nuclear catastrophe to increase its fiscal deficit from last year. The markets have failed to zero in on this problem, he writes, because of all the other squeaky wheels in the global economy — but sooner or later, latch on they will. While the likes of Gross keep telling us this car wreck would surely play out in the bond market, Woo takes the opposite tack. He reasons that the end of Fed bond purchases will drive up the risk premium on Treasury securities — yet nominal Treasury yields may not rise substantially as investors belatedly come around to the observation that the 4% growth everyone was hoping for this year is not going to arrive. And if the Fed is forced by a weakening economy and soft overseas demand for Treasuries to resume bond purchases, the flight from the dollar would surely accelerate. This is merely a risk for now, but it could come to dominate the market’s attention span, which if anything is possibly even shorter than Congress’ own. “Financial markets are poor multi-taskers,” Woo writes. Join the crowd. Also on Fortune.com: The coming commodity price nightmare Lost decade? We’ve already had one The Bernanke-bashing bubble Follow me on Twitter @ColinCBarr.