Markets brood over ailing dollar

Clerks in the Euro Dollar Pit at the Chicago Mercantile Exchange, March 21, 2007. Relatively gloomy U.S. growth expectations -- effectively a decoupling of the United States from the rest of the world -- and a diminishing yield advantage are major factors forcing investors to think long and hard about holding dollars.

LONDON (Reuters) - The Federal Reserve is cranking up its anti-inflation rhetoric, markets have pared expectations for rate cuts and the dollar is by no means a funding currency. So why is the greenback falling fast now?

Relatively gloomy U.S. growth expectations -- effectively a decoupling of the United States from the rest of the world -- and a diminishing yield advantage are major factors forcing investors to think long and hard about holding dollars.

This comes against the perennial concern over funding the U.S. current account deficit and talk of central banks diversifying their reserves away from the dollar.

With the exception of the yen, the dollar is taking a pounding across the board. On Monday it hit a 15-year trough against sterling and a 17-year low versus the Australian dollar, flirted with long-term support against a basket of currencies and came within a cent of hitting a record low against the euro.

"A very powerful reason is decoupling -- the U.S. economy's trajectory is heading in the opposite direction to the rest of the world so for a period the dollar will be vulnerable -- definitely this quarter," said Stephen Jen, chief currency economist at Morgan Stanley.

Some economic indicators lately, most notably the March employment report, were stronger than expected. But most activity and survey indicators point to a slowing economy, which analysts say will feed through into lower growth in the coming months.

In contrast, the euro zone is growing at its fastest clip in six years, Japan's recovery is firmly on track and emerging countries like India and China are driving the global growth engine.

The European Central Bank is expected to raise rates at least once more this year to 4 percent or higher. Fed funds interest rate futures no longer fully price in even one 25 basis point cut from 5.25 percent by the end of the year, compared with more than 50 basis points of easing only a few weeks ago.

"I wonder how strong the U.S. economy really is," said Thomas Stolper, currency strategist at Goldman Sachs in London.

"The U.S. economy seems to be slowing (to) sub-trend growth ... global rebalancing is visibly materializing, the rest of the world is decoupling from the U.S. ... that is consistent with a weaker dollar."

THOSE IMBALANCES AGAIN

Group of Seven finance chiefs at the weekend issued an upbeat assessment of global growth but warned that continued imbalances in global trade could dim the growth outlook and lead to increased protectionism if not addressed.

"I think there is a renewed focus more generally on the U.S. external imbalances, how financeable they are, and the apparent shift in the U.S. attitude towards China which is a nagging concern for the dollar," RBC Capital Markets currency strategist Adam Cole said.

While the U.S. trade deficit has narrowed from record levels approaching $70 billion in mid-2006 to $58 billion this year -- the gap is still considered substantial and fuelled a record current account deficit of $856 billion last year.

Only last week, China announced a record surge in reserves over the last quarter of $136 billion to $1.2 trillion, increasing speculation it will invest more of that stash in non-dollar assets.

"Because we saw equity portfolio flows very strong into emerging markets and we saw commodity, not least oil prices, go up, suddenly these nations were accumulating dollars at a much faster pace than they had been," said Steven Pearson, chief currency strategist at HBOS.

"That meant the diversification/sale of dollars into the developed FX market was accelerated as well -- that has a lot to do with the timing of the (recent dollar) move," he added.

Analysts also noted that the only reference to the much-touted U.S. "strong dollar" policy at the G7 meetings in Washington came from French Finance Minister Thierry Breton.

Publicly, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke made no mention of a strong dollar being in the United States' interest, an omission which some analysts said reflected an unspoken belief that global policymakers see a falling dollar as essential to the global rebalancing.

"We couldn't find a single 'strong dollar' quote from a U.S. policymaker. Interesting," wrote Stolper at Goldman in a post-G7 note on Sunday.

(Additional reporting by Jamie McGeever and Toni Vorobyova in London)