Don’t mistake the U.S. dollar’s recent rally for strength. If anything, it’s a head fake of legendary proportions.

In fact, the dollar’s recent run-up is actually a warning that risks are escalating.

To better understand what I mean here, let’s look at the greenback’s recent performance against the euro. After bottoming at an all-time low of $1.6019 versus the euro on April 22, the dollar has soared nearly 4% and was trading at $1.5428 per euro early yesterday (Wednesday).

Now many of the Wall Street types expect that rally to continue. Just yesterday, UBS AG (UBS) predicted the greenback would rise to  $1.47 in three months. That would be a jump of 5.0% from where the dollar is trading now, and would represent a total rebound of about 8.0%.

I mention this forecast because UBS is the world’s second-biggest currency trader, meaning the Swiss banking giant’s projection is certain to get lots of play.

Here’s my advice on this forecast: Ignore it.

Out of Touch With Reality

The so-called "dollar rally" is illogical, irrational and is unfolding at precisely the wrong moment – which means that many investors who are long on the dollar could get a nasty surprise if they don’t temper their enthusiasm a bit in the months to come.

Granted, there are a lot of things that happen at the wrong time when it comes to the financial markets. But the prospect of watching the dollar rise at the same time that oil and gold are advancing (a scenario that we don’t have right now, given gold’s retreat, but one that I won’t be surprised to see, given current conditions) is downright disconcerting – if for no other reason than the history books show a pronounced negative correlation over time between these assets.

Couple that concern with the reality that the Bush Administration’s policy for the dollar has been one of benign neglect and you can come to only one conclusion: Absent an increase in interest rates by the U.S. Federal Reserve, any increase in the value of the dollar must be viewed as an anomaly.

And anomalies merit scrutiny.

One possible set of answers comes from an unusual source – the London Interbank Offer Rate (LIBOR) system of setting interest rates.

The LIBOR Lambada: The "Forbidden Dance."

LIBOR, in case you’re not familiar with it, is the rate banks charge each other to lend money. It’s the net result of data on loan duration calculations ranging from overnight funds to as much as a year in 10 different currencies submitted by 16 major international banks and published each morning by Reuters.

Even though most investors focus on the U.S. Federal Funds rate, which is the benchmark for such key U.S. financial measures as the Prime Rate, LIBOR drives global calculations involving trillions of dollars of corporate debt, mortgages, financial derivatives and other financial instruments. And that makes LIBOR one of the single-most-important daily interest-rate calculations in the global financial markets. And it may actually be the most important benchmark.

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And that brings us back to what’s happening with the dollar.

Because LIBOR represents the rates banks charge each other as part of the lending process, and because interest rates are an assessment of risk, rising LIBOR rates could be interpreted as an indicator of escalating risk, particularly if rates associated with it increase at a time when central banks the world over seem to be completely committed to lowering rates.

This is immensely troubling, because it appears as if the dollar rally is nothing more than the powerful head fake I mentioned a moment ago.

You see, when banks submit their LIBOR rate-related data, they’re supposed to submit their true borrowing costs honestly and without bias. The entire LIBOR-submission system works on the honor system – meaning there’s no regulatory agency reviewing the information to ensure its accuracy and truthfulness.

Yet, the rates that come from that data serve as the basis for worldwide valuations.

If that doesn’t sound familiar, it should. The same "Old Boys Club" responsible for the global credit crisis is responsible for self-policing its LIBOR data submissions. And we all know where that led when the "true" costs of the credit crisis and the off-balance-sheet transactions began to surface last summer.

And it wasn’t pretty.

In very real terms, no bank wants to submit data that reveals it is having trouble borrowing money or making loans. Not only would such data invite more scrutiny, but it also would potentially raise new valuation questions related to liquidity, bad-loan levels and the remaining levels of off-balance-sheet derivatives exposure at a time when the financial sector least needs it and doesn’t want it.

The upshot: As Money Morning reported to you several weeks ago, there’s no incentive for any member in the LIBOR-submission group to submit data that, while accurate, reveals its weakened state. That means that rising LIBOR rates – instead of signaling a newfound strength in the greenback – are actually demonstrating that the banks don’t trust one another, and are charging a premium for their money in a global-markets game of blind man’s bluff.

Think of it this way. It could well be that the same coterie of global bankers who brought us the global credit crunch could collectively now be manipulating LIBOR – and by extension – the U.S. dollar.

With this crew at the controls, it means that the dollar is gaining altitude, and not because it’s worth more, or because the outlook for the U.S. economy is more upbeat. The dollar is rallying on nothing but increased risk.

Two pieces of evidence back up my theory.

First, the British Banker’s Association has already launched an investigation into some of these LIBOR-related machinations. And when the BBA then announced that it was accelerating its probe, former professional bond trader and private investor R. Shah Gilani pointed out that "LIBOR jumped."

And so did the dollar.

News and Related Story Notes:

• Money Morning Financial Markets Analysis:
  LIBOR Sends Another Shaky Signal to the Global Financial Markets.

• Bloomberg News:
  Dollar Rises After Hoenig Says Inflation May Spur Rate Increase.

• Money Morning Financial Commentary:
  Send in the Clowns: Bush Administration Pursues Economic Policy of Benign Neglect.

• Bloomberg News:
  Gold Trades Near Four-Month Low as Dollar’s Gains Reduce Appeal.

• British Banker’s Association:
  LIBOR: Frequently Asked Questions.

• Bloomberg News:
  Gold Falls in London as Dollar Advances; Platinum Declines.

• Bloomberg News:
  Dollar Rises to Five-Week High on Bets Fed Will Halt Rate Cuts.

• Bloomberg News:
  Yen May Rise to 100 as Global Growth Slows, UBS Says