FXOUTLOOK-Sizzling rally in US dollar may continue

By Wanfeng Zhou

NEW YORK, Oct 31 (Reuters) - The U.S. dollar's blistering rally in October may spill over into next week, as volatile global stock markets and still-tight credit conditions should keep investors on their toes, spurring further unwinding of riskier investments.

The upcoming U.S. presidential election on Tuesday is also expected to add further uncertainty to financial markets. While polls favor Democratic candidate Barack Obama, a surprise win by Republican nominee John McCain can't be ruled out, which may cause some temporary volatility, analyst said.

Developments in the credit and equity markets will remain the deciding factor behind currency moves, while economic data may largely take a back seat although the October employment report will certainly grab some investors' attention.

"Volatility remains so high that it is difficult to offer much guidance on short-term trade," said Todd Elmer, a currency strategist at Citigroup in New York. "But I do think the broader trend remains toward dollar appreciation and a lower euro/dollar because increasingly investors are capitulating on long positions in non-dollar assets."

"We think this phenomenon has only just started and is likely to drive the dollar significantly higher in the months ahead," he added.

The greenback advanced 7.8 percent this month against a basket of six major currencies, on track for its best monthly performance since March 1991, according to Reuters data.

The dollar, perhaps ironically, has been a big winner in the worst financial crisis in decades that started in the United States, as investors dumped riskier assets across the board and scaled back leverage.

That has resulted in U.S.-based investors bringing money home and overseas investors looking for safe-havens, often opting for short-dated Treasury bills.

The foreign-exchange market has seen unprecedented volatility in recent weeks as sentiment swung between risk aversion and risk appetite and stock markets gyrated between gains and losses.

"We have two factors really driving trades right now. There's an incredible lack of liquidity and there's an incredible feeling of uncertainty in the market," said Greg Salvaggio, vice president of trading at Tempus Consulting in Washington.

He said the bigger shadow overhanging market is who will be the next U.S. president because the candidates have very different views on how to fix the economy.

GLOBAL ECONOMIC DOWNTURN

As strains in the credit markets continue to ease following aggressive efforts by the Federal Reserve and other central banks to restore confidence, investors are also shifting their attention to worries about a prolonged global economic downturn.

That should bode well for the dollar and the yen, and analysts said investors should buy these currencies on pullbacks as investors continue to unwind their riskier positions and look for safe, liquid assets.

"Though equity markets have started to show some resilience as October ends, risk-averse U.S. investors are likely to keep reducing their exposure to overseas markets as the global economy suffers very weak growth in 2009," said Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS in Zurich, in a research note.

"Thus U.S. repatriation is likely to keep supporting the U.S. dollar," he added.

On the U.S. economic data front, the monthly nonfarm payrolls report, due out Friday, will be the highlight of a busy week that includes the Institute for Supply Management's manufacturing and service sector indexes, the ADP private sector jobs report, and pending home sales.

Economists polled by Reuters are looking for the U.S. economy to shed 200,000 jobs in October, after a decline of 159,000 in September.

Data released this week including third-quarter gross domestic product have increased fears that a U.S. recession is setting in. But analysts said given the market's obsession with developments in the credit markets, economic data will unlikely have any major impact.

"The dollar is not being driven by economic fundamentals or interest rate variance right now. What it is being driven by is flight to quality," Salvaggio said.

In Europe, interest-rate decisions by the European Central Bank and the Bank of England will take center stage. Economists polled by Reuters expect the ECB to lower rates by a half percentage point, following rate cuts by the U.S. Federal Reserve and Bank of Japan this week. (Editing by Andrea Ricci)