FX OUTLOOK-Dollar waits for more signs of U.S. recovery

NEW YORK, June 5 (Reuters) - Though still vulnerable to selling pressure, the dollar enters the new week with the vague hope that U.S. efforts to revive a moribund economy may finally be starting to pay off.

After tumbling in May, the dollar stabilized this week before rallying sharply on Friday when a report revealed U.S. employers cut 345,000 jobs last month, far fewer than expected and the fewest since the height of the crisis in September.

The euro fell back below $1.40 on Friday after climbing $1.4337 earlier in the week, its 2009 high.

While the rally was partly corrective in nature, some strategists said it may also reflect growing optimism that the United States will be first to emerge from recession.

If subsequent employment and consumer sentiment data this week bolster that view and bond yields continue to rise, some argue the dollar could break out of a pattern in which it's role as a safe-haven helped it rise only on bad economic news.

"That becomes the $2 million question - is this a one-off fluke or is a new pattern emerging," said Marc Chandler, senior currency strategist at Brown Brothers Harriman.

Signs of slower economic decline and fear of a record U.S. budget deficit have combined to push long-term interest rates higher, with the 10-year U.S. Treasury yield reaching a six-month high this week near 4 percent.

That has even sparked Federal Reserve officials to warn the central bank, after cutting benchmark borrowing costs to zero and flooding the banking system with new cash, must be ready to raise rates if recovery begins and inflation fears rise.

Indeed short-dated Treasury yields rose more quickly than yields on the long-end on Friday, suggesting markets were betting the Fed could hike rates sooner rather than later.

"Our view has long been that because of aggressive Federal Reserve policy, the United States would recover first and the dollar would be rewarded," Chandler said. "Now, it seems premature to think the Fed is about to tighten policy, but I do think we have to start talking about it for sometime in 2010."

DOLLAR STILL FACES HEADWINDS

The U.S. data calendar is fairly light at the start of the week, leaving markets to trade largely on Friday's surprising jobs data, said Fabian Eliasson, vice president of currency sales at Mizuho Corporate Bank in New York.

But he said the "jury's still out" on whether a new pattern in which the dollar trades higher on good U.S. economic news is sustainable, while hope for a robust U.S. recovery is fragile, too, especially with the jobless rate at its highest in nearly 26 years.

"Employment is a lagging indicator, so perhaps things have started improving, but there's no question we're still in dire straits," he said. "We're still not seeing job creation, we're just not firing as many people."

Another possible drag for the dollar are lingering worries about a $1.8 trillion deficit, which has helped push up bond yields and sparked fear that the Fed could add to a $300 billion asset purchase program to bring yields lower.

"There are no credible plans to draw down the deficit, and mortgage rates, which are set by long-term credit markets, are going higher, making recovery difficult," said Joseph Trevisani, chief market strategist at FX Solutions in Saddle River, New Jersey.

Morgan Stanley strategists say deficit fears mean that signs of stabilization in the global economy are likely to drive investors out of dollars and into higher-yielding assets and currencies.

"We recommend shorting the dollar against cyclical currencies with strong balance sheets, such as the Norwegian crown and Canadian dollar," they wrote in a research note.

Worries about Eastern Europe and the stability of the UK government may, however, limit euro and sterling gains against the dollar next week.

Sterling has fallen sharply amid fear Prime Minister Gordon Brown's government could collapse, an outcome that appears to have been averted for now with a Cabinet reshuffle.

In Europe, fear that Latvia may have to devalue its currency, wrecking havoc on Swedish banks with heavy exposure to the Baltic states, could undermine confidence in the euro zone, analysts said.

(Editing by Diane Craft)