Americans may be working on paying down their debts, but the federal deficit continues to grow.

President Obama s proposed budget for fiscal 2011 includes a projected shortfall of a record $1.56 trillion in fiscal 2010 a deficit equivalent to about 10.6% of the gross domestic product. The projection is largely the result of temporary recovery measures to stimulate the economy. But those measures can have collateral damage spending so many dollars on recovery has the potential to weaken the U.S. currency.

The dollar has been strengthening recently but took a steep dive last year hitting a bottom in November. Now, the proposed new spending has the potential to slow its climb back.

Of course, that spending is designed to fix other problems. With unemployment still hovering around 10%, the new budget includes tax cuts for businesses that hire new workers and other proposals intended to spur job growth measures that increased the new budget s deficit projections by $98 billion in 2010 and $147 billion in 2011. The administration says that economic recovery alone will bring deficits down from 10% to 5% of the GDP. The administration s current projections also assume that health reform will reduce the deficit by $127 billion from 2011 to 2015.

In the short term, economic growth could continue to strengthen the dollar relative to the currencies of countries with shakier recoveries. In the long term, the dollar could revert to last year s slide if U.S. debt levels look unsustainable. Although America s debt won t weigh on investors as long as the recovery remains the most salient topic, in the long run, it s the only issue, says Rodney Johnson, the president of HS Dent, an economic research and forecasting company.

Here s how the deficit and other factors could impact the dollar:

Spending beyond our means

Since deficit spending became a mainstream tool of government stimulus during the Great Depression, the question for some presidents has not been whether or not to do spend more than we have but how long to keep digging.

Spending does eventually reach a tipping point where flooding the market with currency devalues that currency, Johnson says. Given the state of the rest of the world, the U.S. may not be as close to that tipping point as it could be. We ve got a lot more debt we can add on before we reach that point of no return, because the main alternatives to the dollar the euro and the yen are even shakier propositions, he says.

Keith Hembre, the chief economist for First American Funds, says currency values can sustain a budget s temporary trip into the red. A one-year deficit is probably not a big issue, he says. What s going to be imperative is that a credible path back to fiscal sustainability be put in place at some point in the not too distant future.

More important than deficit spending is the amount of debt held by foreign countries and the U.S. s ability to service that debt, says John Lekas, manager of the Leader Short Term Bond Fund (LCCMX). We need that low dollar to take care of our debt problem, so it s in the country s interest to keep the dollar weak, Lekas says.

Economic news from the U.S., including strong GDP growth for the third and fourth quarters, has been stronger than it has been elsewhere in the world, which has supported the dollar.

Concerns about sovereign debt in Greece, Spain, Portugal and other European Union countries have also strengthened the dollar against the euro, but the dollar is likely to give up those gains if those concerns are put to rest, says Burt White, the chief investment officer of LPL Financial. Greece is almost too small to fail, White says. The ripple effects of failure would be much larger than the actual cost to fix the country s problems, so a bailout is likely and so is a weaker dollar, White says.

Handicapping the Fed

A move by the Fed to tighten monetary policy and raise interest rates would strengthen the dollar, and the recent rally (and slightly rosier language from the Fed) suggests that the market is already expecting such a move, Lekas says. However, European countries are likely to move more quickly to tighten monetary policy in lockstep, so any gains from Fed actions could be short lived, White says. Because America s great economic trauma remains the Depression as opposed to Europe s runaway inflation in the U.S., central banks lean to accepting higher rates of inflation for growth, he says. Europe is exactly the opposite.

The outlook for the yuan

China s recent moves to tighten monetary policy have allowed their currency to strengthen a bit, and could indicate the country is willing to consider letting the yuan float, Lekas says. If China let the yuan float, they wouldn t need such large dollar reserves, and the resulting selloff would weaken the dollar, he says. China s reliance on exports makes such a move unlikely, but even a slight appreciation in the yuan could dent the dollar, Johnson says. The cost of Chinese goods would go up, hurting the American consumer and dragging on growth, he says.

Energy as a haven

With the long-term trajectory for the dollar dragged by debt and other concerns, commodities should continue to be a good hedge against a declining dollar, White says. It s tough to buy gold at all-time highs, but it s going to end up being a brighter spot than will be the dollar, he says. The near-term fundamentals for commodities like oil are also strong at this early point in an economic recovery, White says.