The dollar's best monthly performance since November may prove fleeting as a slowing U.S. economy and falling short-term interest rates encourage investors to use the currency to fund investments in higher-yielding assets.

The U.S. currency's value will be unchanged from current levels by year-end, down from last month's predicted 2 percent appreciation, according to analyst forecasts compiled by Bloomberg. Bets remain tilted against the greenback even after last month's 2.3 percent gain in IntercontinentalExchange Inc.'s Dollar Index, Commodity Futures Trading Commission data show.

While the dollar gained against 14 of the 16 most-traded currencies in May, it fell last week after weaker-than-forecast reports on manufacturing, employment and consumer confidence led traders to raise bets that the Federal Reserve will keep rates near zero. Traders also found less reason to seek shelter in the currency as European officials agreed to provide more financial aid to Greece and German Chancellor Angela Merkel said the European Union is committed to keeping the euro intact.

“The dollar's rebound is not a turning point in the bear trend,” said John Normand, head of currency strategy in London at JPMorgan Chase & Co., the world's fifth-biggest currency trader according to Euromoney Institutional Investor Plc. “A sustained dollar rally requires a Greek default, a global recession or aggressive Fed tightening. And those are not likely to happen this year.”

Gains Reversed
Last month's 1.5 percent rise against nine exchange rates tracked by the Bloomberg Correlation-Weighted Indexes was the dollar's first gain since rallying 4.1 percent in November. Only the Swiss franc and New Zealand dollar appreciated more.

The dollar weakened 0.9 percent last week as measured by the gauge. It fell 1 percent against the euro to $1.4635. The single European currency strengthened against all the most-traded counterparts apart from the South African rand and the Danish krone.

Falling short-term rates in the U.S. means that borrowing in dollars to buy currencies of economies with higher yields has become profitable in the last two weeks, returning 0.4 percent, after losing 2.4 percent from April 29 through May 23, according to an index compiled by UBS AG.

Traders who borrowed in U.S. dollars to buy Australian assets have earned 2.2 percent after losing 3.3 percent in the first three weeks of May, according to data compiled by Bloomberg.

The Fed has kept its target rate for overnight loans between banks in a range of zero to 0.25 percent since December, 2008. The European Central Bank raised borrowing costs in April for the first time in almost three years, bringing the main refinancing rate to 1.25 percent.

Relative Yields
China, Russia, Norway, Sweden, Poland, South Korea, Thailand, India, Indonesia, the Philippines, Malaysia, Taiwan, Chile and Brazil have raised borrowing costs this year.

Treasuries due in one to three years yield 1.01 percentage points less on average than government debt with similar maturities in the rest of the world, Bank of America Merrill Lynch indexes show. That compares with 0.59 percent less at the beginning of the year.

A weaker dollar hasn't hurt the ability of the U.S. to attract the foreign capital needed to fund a budget deficit in excess of $1 trillion. The Treasury has received $3 in bids for every dollar auctioned this year, compared with last year's record $2.99, Treasury data show.

U.S. exports reached $172.7 billion in March, up 4.7 percent from the prior month and the biggest gain since 1994, according to a government report.

End of QE2
Dollar weakness is unlikely to be uniform. It may appreciate to $1.40 versus the euro by the end of the year, according to the median estimate of 51 forecasters in a Bloomberg News survey. It's projected to gain 8.2 percent against the yen, 0.9 percent versus the Norwegian krone and 3.7 percent to the Australian dollar, separate surveys show.

The dollar may also get support as the Fed stops printing money to buy $600 billion of Treasuries in a second round of so- called quantitative easing, or QE2. The end of the program this month reduces the availability of the currency in the market.

“If the U.S. stops debasing the currency or easing, then it's time for investors to stop selling dollars,” said Geoffrey Yu, a currency strategist in London at UBS AG, the third-largest foreign-exchange dealer. “The risk to this view is that the market is concerned the Fed could be prompted to increase asset purchases to keep growth expectations intact.”

Yu said he expects the dollar to gain to $1.35 against the euro in the next three months.

Risk Reversals
Traders aren't as optimistic. Demand for contracts protecting against a drop in the euro versus the dollar is down from the highest since December.

The so-called risk reversal rate for one-month put options granting the right to sell the euro fell to a 1.64 percentage- point premium over calls giving the right to buy, down from 1.94 percentage points May 26.

“The general trend of dollar weakening will continue until the Fed signals that it's going to raise rates,” Greg Anderson, a senior currency strategist at Citigroup Inc. in New York, said.

The outlook for higher U.S. rates this year faded last week as reports showed manufacturing for May expanded at the slowest pace in 20 months, the unemployment rose to 9.1 percent in May and consumer confidence fell to a six-month low.

Futures on the Chicago Board of Trade show traders see a 10.9 percent chance the Fed will increase its target rate in 2011, down from 22 percent a month ago.

Trimming Forecasts
Economists at Barclays Capital Inc. cut their forecast for second-quarter economic expansion on June 3 to a 2 percent annual rate from a prior estimate of 3.5 percent. They lowered their projection for the third quarter to 3 percent from 3.5 percent. The U.S.'s 1.8 percent growth rate last quarter compares with 2.5 percent in the euro zone, 3.92 percent in Canada and 6.4 percent in Sweden.

Net bets the dollar will drop against the euro, yen, pound, Australian dollar, Canadian dollar and Swiss franc increased to 126,029 as of May 31, from 101,398, the week before, the least since January, Commodity Futures Trading Commission data show.

The Dollar Index, which tracks the greenback against the euro, yen, pound, Swiss franc, Canada dollar and Swedish krona, fell to an almost one-month low of last week of 73.698 from 76.366 on May 23. The gauge is weighted 57.6 percent to movements in the euro, which has the support of European lawmakers and central bankers.

Investors are betting the European Union and International Monetary Fund will delay a sovereign default in Greek debt until after the European Stability Mechanism comes into effect in 2013. EU and IMF officials agreed last week to pay the next installment to Greece under last year's 110 billion-euro ($161 billion) bailout, paving the way for an upgraded aid package.

No 'Euro Problem'
“We don't have a euro problem in Europe,” Merkel said in a speech in Singapore June 2. “We have more of a debt problem.”

Germany is committed to the euro, which is stable, she said. The outlook for growth in the country's economy, Europe's largest, is “very positive,” Merkel said.

“Europe might not be perfect, but leaders are committed to the problem and I think they will find a solution,” said Pierre Lequeux, London-based head of currency management at Aviva Investors, which oversees about $370 billion. The “U.S. is in an environment where the problem is ahead of it and not behind it,” he said.

Bloomberg News

Instant Insights /

Dollar Gains Threatened as Growth Slows

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