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The weakness in the U.S. dollar has often been cited as a main reason behind the spike in oil prices this year, but some market observers are getting increasingly worried over the potential harm rising oil could do to the greenback.

Long-term evidence suggests that oil and the Dollar Index have shown a strong negative correlation at about 0.7. In other words, as oil prices rise, the dollar would fall and vice versa. The logic behind this is simple: as oil rises, consumers scale back spending, therefore slowing down the economy and leading to lower interest rates and a depreciating currency.

This inverse relationship didn’t hold in previous oil shocks, said Kathy Lien, chief strategist at DailyFX.com. But, she said, the current problems in the U.S. economy have made the dollar more vulnerable to downside risks.

There were three occasions over the past half century when oil prices spiked abruptly.

In 1973, oil jumped 134% after members of the then OAPEC (OPEC plus Egypt and Syria) announced that they were no longer exporting oil to nations that supported Israel in conflict with Syria and Egypt – a move that effectively shut down exports to the U.S., Western Europe and Japan.

In 1979, the price of crude oil soared 118% between January and December, with many analysts attributing the spike to the Iranian revolution and a gasoline shortage.

In both cases, the trade-weighted U.S. Dollar Index, which measures the greenback against a basket of the world’s major currencies, initially rallied along with oil as the Federal Reserve hiked interest rates to combat inflation, then sold off as growth contracted.

But the dollar behaved differently during the 1990 oil shock. Crude prices jumped 113% between June and October that year as a result of the Gulf War. The dollar, which was already in a downtrend because of Federal Reserve’s monetary easing, saw continued weakness this time as U.S. economic growth slowed.

Lien said the characteristics surrounding the oil price surge this time are more similar to the one in 1990 than those shocks of 1973 and 1979. “Therefore, it is easy to understand why the U.S. dollar has continued to weaken despite growing inflationary pressures,” she said.

The Federal Reserve has been consistently cutting interest and these rate cuts have played a far more dominant role in the price action of the dollar than the rise in oil, Lien said. “The market basically doesn’t believe that the Fed will start raising interest rates - and they have good reason to feel this way because based upon the last three oil shocks, growth in coming quarters should contract.”

Asset managers woke up to a pleasant surprise on Tuesday morning - a Goldman Sachs sector upgrade.

After sitting on the sidelines because of concerns over downward estimate revisions and equity retail outflows amid weak stock performance, Goldman Sachs said it’s back in the game playing a more “offensive” position. The firm said it’s emphasizing asset managers with retail equity market and beta sensitivity at attractive risk-rewards, and suggests investors seek financial stocks without ongoing business model concerns or exposure to deteriorating credit, funding and capital trends.

Goldman raised its coverage view on asset managers to attractive from neutral, and upgraded Franklin Resources to conviction buy (from neutral) and Janus to buy (from neutral).

‘As Fed policy sets in, and past relationships take hold, we see investors moving back into equity funds and out of “safe haven” money market funds,’ - Goldman Sachs

“[Asset manager] stocks have bounced off the bottom, but we still see room for [price-to-earnings] multiple expansion as investor expectations improve amid ‘less-worse’ news from financials, a stabilizing equity market backdrop and an accommodative Fed,” Goldman said in a research note. The firm doesn’t expect this trend to endure in the near term, but anticipates a recovery in equity flow trends in the second half of 2008, which is not yet priced into the stocks.

“Many stocks offer upside twice that of downside risk, balance sheets are strong, and - looking a bit further out to 2009 - valuations appear extremely compelling,” the firm said. Specifically, Goldman said Franklin Resources offers the best trade-off between valuation and fundamentals, with its risk-reward framework suggesting 3-to-1 upside-to-downside.

“As Fed policy sets in, and past relationships take hold, we see investors moving back into equity funds and out of ’safe haven’ money market funds,” Goldman said.

If anything comes of the Senate probe into the Fed-backed JPMorgan-Bear Stearns tie-up, it’s a higher price-tag on the deal, according to Sanford C. Bernstein analyst Brad Hintz.

Asked about the likely outcome of the investigation, Hintz told Thomson Financial News, “None. Come on, it’s a congressional investigation.”

The one other possible result could be that the price of the deal rises, the former Lehman Brothers chief financial officer said, because the current offer of $10 a share undervalues the troubled investment firm. Hintz has valued Bear Stearns at around $7 billion “in an unpressured environment.”

Now that the Fed is giving brokers access to the discount window, some on Wall Street may be speculating that Bear holders can use that as a bridge to negotiate a better deal, he said. But at the time the deal was struck, Bear was in no position to negotiate better terms.

“The fact the Bear stockholders were able to get what they did is very good,” Hintz said. “When Drexel failed, it got nothing.” Drexel Burnham Lambert Inc. was a major investment bank that failed in 1990 amid felony securities fraud charges relating to its heavy investment in junk bonds. At its height, it was the fifth-largest investment bank in the United States.

In exchange for the headaches related to buying Bear, JPMorgan gets Bear’s prime brokerage, high-net-worth and asset management operations, which Hintz sees as credible businesses for JPMorgan. The former executive countered arguments that the buy will saddle JPMorgan with a floundering mortgage business. “You can argue that the mortgage market won’t be as large,” Hintz said. “But you can’t make the argument that the mortgage market won’t exist. There will be something that will be the equivalent of Alt-A and securitizations.”

And although there are problems in Bear Stearns’ hedge fund business, “its clients will sleep soundly,” once it’s in JPMorgan’s hands, Hintz said.

If consummated, the deal “certainly is a feather in [the] cap for Jamie [Dimon] and a personal disaster for employees of Bear,” Hintz said. Pointing to the Fed’s rescue of Continental Illinois, Hintz noted that some may later ask why the Fed didn’t get some equity in the deal if it turns out to be as “wonderful” for JPMorgan as the Continental Illinois purchase turned out to be for the Fed.

In 1984, the Fed rescued Continental Illinois, the seventh-largest bank in the U.S. by deposits at the time. When no buyers could be found for the bank, and the government feared a failure would cause a crisis that would cripple the entire banking system, the Fed removed the bank’s executives and bought most of the its equity. It sold the last of its stake in the bank in 1991.

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Before everyone goes running out onto Wall Street with hands raised and shouts of jubilation because Punk Ziegel analyst Richard Bove has said the financial crisis is over, let’s clarify - he also said we aren’t out of the woods yet.

“This comment sounds ridiculous given the conviction on the part of most commentators that the worst is yet to come; the extent of the decline is unknown; and that the length of the decline is similarly unclear,” Bove said. “However, I do, in fact, believe that the crisis is over. There will be more negative developments but they will be meaningless. Further, let me be clear, even though the financial crisis is over, the problems facing the economy are not.”

Alright, so the slowdown in the economy spurred on by a housing slump and weakness in the dollar isn’t over. But with that said, let’s throw our hands up and run out into the streets with shouts of jubilation because Richard Bove said the financial crisis is over! On second thought, let us take a closer look at how he came to that conclusion.

For Bove, the insolvency of Bear Stearns was the triggering event that sent fear rippling through the markets and ignited the Federal Reserve and Treasury into action. “The actions taken by the Fed were innovative, dramatic, and, in my view, brilliant because they were right to the problem,” the analyst said.

In the past two weeks, the Fed has cut the overnight target rate 75 basis points to 2.25%, cut the discount rate 100 basis points to 2.5%, agreed to swap $200 billion in securities with banks so that they can repo the securities and increase their liquidity, extended the availability of its discount window to investment banks, and agreed to backstop $30 billion of Bear Stearns’ illiquid securities. The Treasury, on the other hand, has approved Fannie Mae and Freddie Mac’s ability to increase their lending capacities and to buy and insure mortgages that are over $700,000 in size.

“The Federal Reserve has actually created a template that will increase liquidity in the banking system and, just as importantly, bank profits,” Bove added. “The moves at the government sponsored enterprises are also likely to increase bank profit.”

He noted that all of the non-conforming mortgages that the banks have made with face values below $700,000 are now conforming and since non-conforming loans carry much higher yields than conforming loans, it is now possible for the banks to sell the old non-conforming mortgages at high profit and GSEs will now have the money to buy them.

“An environment has been created that will pump profits into the American banking system,” Bove continued. “Investors are so focused on the potential for loan losses and the flawed valuations created by an obscenely invalid accounting rule supported by a soporific SEC that they are missing this fact. The last time an opportunity of this nature existed to buy bank stocks this cheap was in 1990. The next time will be in 20 years. This is a once in a generation opportunity.”

Ok, now you can raise your hands and shout.

Proponents of a strong U.S. dollar, especially those that suffered through the last currency crisis in the mid-1990s, have had to bite their tongues the last several years, as it was the weak buck that helped save the U.S. economy in the aftermath of the Internet bubble’s collapse.

In the current slowdown, a sliding greenback seemed another perfect solution. With corporate America and the government banking on the strength of overseas economies to offset a domestic slowdown, a lower dollar would provide a bigger boost to earnings received from abroad.

An orderly decline can be good, but things have gotten a bit out of hand.

Anytime one market, especially one the size of the $3 trillion global foreign exchange market, gets really, really messy, there will be repercussions. Financial markets are about order — without it, risk levels rise, and it becomes harder to make money as traders’ hands get cuffed by nervous management. It’s tough for one trading desk to look over at another desk going crazy, and not feel a bit anxious.

And the dollar’s drop through the 100 yen mark on Wednesday reminded those that survived that last currency crisis how disorderly things can get.

The biggest worry of a falling dollar is that foreign investors, who own large amounts of U.S.government debt, will take their money home. That would send bonds yields soaring, which in turn increases loan costs for consumers, and the stock market reeling.

Stocks are already teetering. If the bond market goes, especially in an environment when the Fed is trying to lower interest rates to stave off recession, then the U.S. economy is in big trouble.

The bond market still seems OK at the moment, although yields are rising relative to overnight rates. But the economy is already in trouble, and a weak dollar is helping contribute to consumers’ pain by supporting, if not actually causing, the historic surge in commodity prices.

It’s no wonder that President Bush, who on record had always supported America’s so-called strong dollar policy (what he supported behind the curtain seemed totally different), didn’t just say on Wednesday that he backed a strong greenback, he went as far as saying that a weak dollar was bad. He’s not the only one.

Government officials around the world have also stepped up the banter against “excessive” dollar moves. While it’s nothing new for overseas officials to talk down the buck, recent chatter has a bit more of a “coordinated” feel to it, just like how the Federal Reserve worked with other central banks to helped ease the credit crisis.

And didn’t the Fed just increase currency swap lines to a number of other central banks?

Whatever the next move, and whoever makes it, something better be done, and soon. If we wait till Obama, Clinton and McCain start talking about dollar policy, it’ll be too late.

Shortly after the Federal Reserve announced plans to inject primary dealers with $200 billion in cash on Tuesday, shares of the Financial Select Sector SPDR ETF (XLF) spiked as investors hoped the move would add much-needed liquidity to cash-strapped financial institutions. However, when the news had been fully disseminated and cooler heads prevailed, the XLF gains were trimmed as analysts and investors speculated on the more poignant question of the day: What happens in 28 days?

“Essentially, it’s a wash,” Thomson Squawk Box analyst John Forman said. “The move doesn’t really add anything new to the system. What’s going to happen 28 days later when the Fed takes back the Treasury paper? Banks need to redevelop trust with one another for there to be any chance of a long-term solution.”

The Fed, thinking out of the box on Tuesday, tried to develop a new, two-prong weapon in its fight against the credit and liquidity crunch, lending up to $200 billion of Treasury securities to dealers for a term of 28 days. The injection will come in the form of a Term Securities Lending Facility (TSLF) auction, where the dealers will be allowed to pledge other, more illiquid securities as collateral, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency “AAA/Aaa”-rated private-label residential MBS.

“The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally,” the Fed said in its statement.

Increases in its existing swap lines with the European Central Bank and the Swiss National Bank served as the Fed’s second prong. The FOMC extended the term of these swap lines through Sept. 30, 2008, and will now provide dollars in the amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively.

“This is the more interesting aspect of the package,” Forman said. “With the dollar hitting record lows against the euro and the Swiss franc, this opens the door for a possible currency market manipulation in support of the dollar. That is not to say that the central banks will do this, but it at least opens the possibility for a meaningful intervention, which is something we haven’t seen in a long time.”

At least one analyst speculated that a solution to the credit and liquidity problem would need to be fiscal rather than monetary.

“When it comes to the government deficit, there is the good, the bad, and the ugly. The good stems from cutting taxes, the bad from excess government spending, and the ugly from a recession,” IFR Markets analyst Ed Rombach said. “With the U.S. markets heading into a recession, we need more of the good - a tax cut.”

Either way, investors saw something in the move that sparked hope, as they sent the XLF up to its intraday high of $25.08 within the first 10 minutes of Tuesday’s trading session. The financial sector ETF has since given back 78 cents to change hands at $24.30, up 2.8% in mid-day trading.

Because economists have said the U.S. needs to create about 100,000 jobs each month to keep up with new entrants to the workforce, and payrolls have fallen for the second straight month, then the recession must officially be here. The jobs report says so.

Early Friday, the Labor Department said U.S. employers shed more jobs last month than in any month in almost five years. Payrolls fell by 63,000 in February, and January’s 17,000 decline was revised lower to 22,000.

The latest figures pushed the three-month moving average to a 15,000 decline, the lowest level since July 2003.

“Today’s jobs report is the nail in the recession coffin as the losses in payrolls are not only deepening but also broadening into other sectors,” said CMC Markets Chief Forex Strategist Ashraf Laidi. He added that annual inflation above 4.0% and annual average hourly earnings growth at less than 4.0%, puts real earnings at their lowest in two years.

Bernanke may have already hinted that the U.S. is in a recession when he said today’s conditions are more challenging than in 2001, Laidi said. This downturn will be especially challenging, bearing “an ominous combination of the worst of the last three recessions; namely rising inflation of the early 1980s; surging oil prices and housing recession of 1989-90; and falling equity markets of 2001-02.”

“The 63,000 drop in Feb., and the directional change in the last three months is consistent with recession, though the 4.8% unemployment rate is not,” said Joeff Hall, Thomson Financial managing economist. “I’m discouraged by the lack of job creation, but I believe firms are holding back on hiring because of uncertainty rather than outright economic conditions. That said, the worsening credit crisis is making it tougher for me to cheer about this economy.”

Despite the jobs report, which was distinctly worse than the 25,000 job gain which analysts polled by Thomson’s IFR Markets had expected, stock markets and equity futures rose earlier in the session after the Federal Reserve announced it will raise the amount of liquidity in its TAF auctions to $100 billion to “address heightened liquidity pressures in term funding markets.” Investors took back gains, however, and the Dow Jones Industrial Average lost 146 points by the end of the session.

Laidi predicts that, despite the Fed’s stepping up of liquidity operations, it will be forced to slash benchmark interest rates to 2.00% by end of the second quarter. He sees about a 70% chance of 1.50% Fed funds rate by end of year. The payroll report, he added, is an “indisputable negative for the already damaged dollar especially considering the [European Central Bank's] tacit support for its record-high euro.” Nonetheless, the U.S. dollar index ended 5 cents higher at $73.04.

One question to ask is how could job report estimates have been so wrong. Part of the answer, Laidi said, is related to why most economists never expected rate cuts in 2007, or recession in 2008.

Federal Reserve Chairman Ben Bernanke is fighting a three-front war: recession, inflation, and credit market depression. The question, then: Is the Fed capable?

The Fed has cut rates and taken a series of liquidity-boosting measures over the past few months, yet there’s no sign the credit market crisis is receding; the U.S. economy remains on track for a recession.

The Federal Reserve said on Friday it’ll raise the total size of its March TAF (Term Auction Facilities) auctions to $100 billion and begin 28-day term repurchase agreements that are expected to total $100 billion, to “address heightened liquidity pressures in term funding markets.” The TAF is a targeted facility that allows banks to access funds at interest rates lower than those offered at the discount window. The Fed also said it’ll expand the ways it delivers liquidity to banks, which includes using less-liquid assets as collateral for term repurchase transactions.

You can bring a horse to water, but you can’t make it drink. Senior Fed officials warned that while these decisions were in response to the rapid deterioration in term funding markets, they are not sure their new measures will calm the turmoil in the credit markets.

Financial markets are still expecting the Fed to aggressively lower interest rates in the coming months. An Action Economics weekly survey showed all are expecting at least a 50-basis points reduction in the federal funds rate to 2.5% from the current 3% by the March 18 policy-setting meeting. According to the survey, fed funds estimates ranged from 2.50% to 2.25% for the March policy meeting, and 2.5% to 1.5% by June.

But the question remains: is it possible that no matter how low the Fed cut rates, it won’t stop the economy and credit markets from worsening? New York Fed President Timothy Geithner said very directly in a speech Thursday that “even with those reductions in short-term interest rates in place, financial conditions have tightened as risk spreads on a wide range of asset classes and institutions have increased considerably.” He said “we cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation.”

Tony Crescenzi, market strategist at Miller Tabak, is more optimistic, believing the Fed still has more aces up its sleeve. if the Fed’s new TAF measures fail, and if the term markets seize up, Crescenzi said he would expect that “the Fed would consider purchasing agencies for their own account.”

“The Fed currently owns only Treasuries but has the authority to buy agencies,” he said. “Another possibility mentioned by Bernanke in 2002 is the idea that the Fed would buy long-term Treasuries. These are both extreme measures but they are potent tools.”