Forget the low, investors betting on dollar to rise

LONDON (Reuters) - Even as it recorded record lows against the euro on Wednesday, the out-of-favor dollar could turn out to be an unlikely beneficiary of the economic misery afflicting the United States.

Long-term investors have begun betting on the greenback to gain strength against most major currencies over the coming year, citing, among other things, the seemingly contradictory notion that it will benefit from a recession or slowdown.

One view, expounded by Investec Asset Management, has it that no matter how the U.S. and global economies proceed, the dollar does well.

Under scenario one, the U.S. has a mild recession but recovers quickly with the help of lower interest rates from the U.S. Federal Reserve. Once the Fed stops cutting, investors buy the dollar because rates and the economy will be heading up.

The second scenario is that the U.S. economy suffers a heavy downturn and drags the global economy with it. This would prompt U.S. investors to bring their money home and global investors to seek safety, both of which would boost the dollar.

"For the second part of the year we expect it to be win-win for the dollar," said Thanos Papasavvas, Investec AM's head of currency management, adding that he expects the dollar to remain weaken before then.

On top of this, dollar weakness and a slower U.S. economy in themselves work to improve the large U.S. current account deficit that has dragged down the currency in the first place.

So expectations for a stronger dollar are growing.

Some 53 percent of respondents to Merrill Lynch's latest poll of fund managers, for example, said the dollar was currently undervalued, while the number holding underweight dollar positions has been steadily falling since November.

Hedge funds, too, have been closing out their short dollar positions, according to Societe Generale. That is, they have stopped betting on it weakening.

And Reuters latest foreign exchange polls point to the dollar strengthening against the euro, pound sterling, Japanese yen and Swiss franc over the next 12 months.

HEADING HOME

Part of the view that the dollar is set to rise is based on the fact that it has already weakened so much against other major currencies.

As well as Wednesday's low against the euro, the dollar index, which tracks the greenback against a basket of six major currencies, hit its lowest level since the index was launched in 1973.

The dollar is also at a more than 11-year low against a broad range of currencies on a trade-weighted basis.

"In the short run, it probably is oversold," said Roger Noddings, chief investment officer of HSBC Investment UK, adding that it was one of the factors prompting his firm to take a hard look at its long-standing underweight stance on U.S. assets.

But the major driver for the dollar is likely to be a mix of interest rate prospects and plain old fear about the future.

Although the Fed is expected to continue cutting rates for now -- perhaps as much as 75 basis points below the current 3.0 percent -- many investors are looking ahead to when it stops and begins hiking again.

By that point, probably around mid-year, many expect other central banks, even including the hawkish European Central Bank, will be in cutting mode, shifting interest rate momentum to favor the dollar.

At the same time, worries about deeper problems in the global economy, from slowing growth to stresses in the banking sector, are seen favoring the dollar.

This is because U.S. investors tend to bring their money home in times of trouble and other investors often move into U.S. assets in a search for safety.

The repatriation potential is huge. In mid-2007, U.S. investors held nearly $5.5 trillion in foreign securities.

"Over the past five years investors have massively used their dollars to buy foreign assets," said Vincent Chailley, head of global management at Credit Agricole Asset Management in London.

"This massive flow that was dollar negative over the past five years is going to reverse or at least to stop," he said.

Not everyone goes along with this, of course. For example, Millennium Global Investments, a currency specialist, reckons that although a major economic meltdown would be dollar positive, anything less that that would not be, leaving recent trends in place.

And there is little belief, even among those expecting dollar gains this year, that strengthening will be sustainable over the longer term.

The fundamental problems that have weakened the currency in the first place, notably the current account deficit, while likely to improve, are still significant.

"It is still an alarming level of deficit," HSBC's Noddings said. "Fundamentally, the dollar looks a bit of a basket case."

But certainly for the medium term, through the second half of this year, there appears to be a new investment mantra of gather ye greenbacks while ye may.