FOREX-Dollar pauses after rallying to three-year high

Mon Jul 8, 2013 7:50am EDT

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By Anooja Debnath

LONDON, July 8 (Reuters) - The dollar, which rallied to a three-year high against a basket of currencies on Monday, took a breather as investors booked profits on its rise and waited for more evidence the Federal Reserve will wind down its stimulus.

But analysts said the current retracement in the dollar was temporary and it will resume its uptrend as the Fed looks poised to power down its massive stimulus programme as early as September if economic data continues to improve.

By contrast, the European Central Bank and the Bank of England were more likely to ease monetary policy, while the Bank of Japan was expected to continue with aggressive stimulus, keeping the euro, sterling and the yen weak.

Markets would focus on Fed minutes on Wednesday and any further hints on tighter policy could drive the dollar higher.

The dollar index was down 0.25 percent at 84.341, having hit 84.588 earlier, its strongest since July 2010.

"The dollar's strength over the course of last week was especially swift, I think the speed was overdone and so this setback is normal," said Ulrich Leuchtmann, head of FX research at Commerzbank. "Now markets are positioned to take profits from these moves, but this is simply a pause."

Leuchtmann added that while he still expects the dollar to strengthen broadly in the longer term, the move higher will not be smooth as there was scope for further corrections.

The euro was last up some 0.2 percent at $1.2850.

The single currency was helped by news that Greece looks likely to reach a deal with foreign lenders on its latest bailout review and by an improved political situation in Portugal.

But the euro was still close to a seven-week trough of $1.2806 plumbed on Friday. The next key levels for the euro are the mid-May low of $1.2796 and the early April low of $1.2740.

Analysts said the euro would find it tough to make any significant gains against the dollar after ECB President Mario Draghi's pledge that interest rates would stay low for an extended period.

"It looks like we will have a clearer diversion, with growth gaining momentum in the U.S. and the euro zone bumping along the bottom," said Niels Christensen, currency strategist at Nordea.

"I expect interest rate differentials to continue to move in favour of the dollar and to pull euro/dollar lower."

The divergence is clear in bond markets, with 10-year Treasury yields spiking 23 basis points on Friday to around 2.75 percent, highs last seen in August 2011. The spread between Treasury and bund yields gapped to the widest since 2006.

The dollar was flat at 101.18 yen, having earlier hit a one-and-a-half month peak of 101.54 yen.

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