FX OUTLOOK-Dollar likely to see further bounce next week

By Gertrude Chavez-Dreyfuss

NEW YORK, March 20 (Reuters) - The U.S. dollar is likely to gain more ground next week as investors further unwind positions in commodities after pulling oil and gold prices off recent record highs as they reduced risky positions built on borrowed money.

On Thursday, gold posted its largest weekly loss in 25 years, while oil and base metal prices extended falls on fears of a decline in global demand if the United States slips into recession.

With the drop in commodities, the dollar rose from historic lows against the euro and Swiss franc, gaining 3.0 percent since the single European currency hit record highs at $1.5904 EUR= on Monday. Against the Swiss franc, the dollar has risen 5 percent since falling to lifetime peaks around 0.9637 francs CHF=.

For now, analysts say it's not clear whether the current correction in commodities was just profit-taking or enforced liquidation by hedge funds on higher margin calls. Nevertheless, they believe the sell-off has further to run, which could spark a rally in the dollar index above 73.00 .DXY.

"This dollar strength will continue next week. I think this correction in the dollar and commodities still has a long way to go," said Joe Francomano, vice president of foreign exchange trading at Erste Bank in New York.

Currency traders expect the euro to trade between $1.5275-$1.5650 against the dollar next week.

Francomano predicted the euro will not trade above $1.59 this month. "I don't believe that dealers added new long positions in the euro above $1.58."

Estimates from Credit Suisse suggested the euro is overvalued by about 33 percent against the dollar on the basis of purchasing power parity, which measures the relative value of two currencies using a basket of goods.

"Euro/dollar is in 'overshoot' mode and we had never expected it to reach as high as 1.59," said Chris Turner, ING head of FX strategy at ING Capital Markets in London.

He added that the euro is about 30 cents above its long-term real effective exchange rate and merely 3 percent to 5 percent away from the highest (implied) euro level since the free float of the dollar in the 1970s.

"We thus have a very hard time seeing euro/dollar sustain levels in the $1.60-65 area," Turner said.

Financial markets on Monday are closed in the euro zone, London, Sweden, Norway, Switzerland, South Africa, Australia, Hong Kong, Japan and Australia. With little volume that day, analysts expect volatile price movements.

U.S. INFLATION DATA IN FOCUS

In terms of U.S. economic data, currency analysts say the market will look to housing data on Monday and Wednesday for clues on the extent of the slowdown in the sector.

Traders will also probably give more focus than usual on the release of the personal consumption expenditure (PCE) core deflator, the Federal Reserve's preferred inflation gauge.

In its accompanying statement after it slashed benchmark interest rates by 75 basis points to 2.25 percent on Tuesday, the Fed said it would keep a wary eye on prices and expressed concern that inflation might not decline as expected.

"If it (core PCE) prints at 2.0 percent year-on-year as we expect though, this would pull it back to the top of the Fed's comfort zone," said Calyon in a research note. "But the continued financial market turmoil should ensure that the downbeat activity signals overwhelms inflation."

The fall in commodity prices, moreover, should help ease inflation concerns.

Analysts will also keep a close eye on the global financial sector, especially in the wake of Bear Stearns' near collapse last week. More indications of troubles at U.S. banks could weigh on the dollar as well.

Recent news highlight the sector's vulnerability. Shares of Merrill Lynch tumbled on Wednesday after the investment bank said it was suing XL Capital Assurance Inc., a unit of Security Capital Assurance Ltd., to prevent the bond insurer from backing out of credit guarantee contracts.

On Thursday, Credit Suisse shares dropped after the Swiss bank cautioned that it was unlikely to be profitable in the first quarter due to big debt write-downs. (Editing by Leslie Adler)