Doubts Arise Over U.S. Dollar's Strength

The dollar is stumbling as investors begin to question the relative strength of the U.S. economic recovery, which had powered a rally in the greenback in the first half of 2013.
The WSJ Dollar Index, a gauge of the dollar's exchange rate against seven of the world's most heavily traded currencies, is down 4% in the past month and hit a seven-week low on Friday. Before the selloff, which began after the dollar hit a three-year high in early July, the U.S. currency was up 8.3% for the year.
Driving the reversal: a shift in views on when the Federal Reserve might start reining in some easy-money policies that are a legacy of the financial crisis, many fund managers say.
Many investors had piled into the dollar earlier this year on the belief that robust growth in the U.S. would lead the Fed to scale back its bond-purchase program, which has been pumping $85 billion into the economy each month, in the fall.
Not only would a receding flood of dollars raise the greenback's value, the positive signal it would send about the U.S. economy would give the dollar additional fuel by attracting money flows from outside the U.S., analysts say.
However, disappointing economic data, mainly weaker-than-expected jobs growth and tepid retail sales, have prompted some currency investors to back away from bullish dollar bets that were based on the Fed reducing—or "tapering"—bond purchases in September, well before other major central banks would be ready to start tightening monetary policy.
Investors have slashed bets on a rising dollar by 49%, to $21.7 billion, since late May. Then, the value of wagers hit its highest level since at least 2007, when the U.S. Commodity Futures Trading Commission first started to track the data. The number reflects investors' net position in the futures market.
"We are at this turning point where investors aren't sure whether this strong-dollar thesis is really going to hold up," says Samir Sheldenkar, an investment partner at Harmonic Capital Partners LLP, a London hedge fund with $1.2 billion under management. The fund recently pared back bets on a stronger dollar because the rate of job growth in the U.S., which the Fed is closely watching as it mulls a pullback, hasn't picked up since the start of the year.
Now, investors like Mr. Sheldenkar say tapering is more likely to happen in December or even later.
The Fed has said it won't start pulling back on bond purchases until the U.S. labor market sees "substantial" improvement. In July, the U.S. economy added 162,000 jobs, less than economists had expected.
At the same time, there are signs that Europe's year-and-a-half-long recession is coming to an end, enhancing the allure of the euro. As well, fears that a slowdown in China would drag down the global economy appear overblown for now, a factor that could revive the appeal of riskier assets such as emerging-market currencies.
Although the selloff in the dollar is in its early stages, the implications could be wide-ranging. For example, in the longer term, a weaker dollar could bolster corporate earnings, as multinational companies find that profits made outside the U.S. are worth more when translated into dollars.
Currency investors are focusing on the next jobs report, slated for release on Sept. 6, because they believe it is likely to dictate the Fed's next move at its Sept. 17-18 meeting.
If the Fed doesn't announce tapering then, the dollar could face a bumpy ride lower, analysts and investors say. Conversely, if the central bank says it will cut back on the stimulus, the dollar rally could resume.
"The trade is no slam dunk, and the dollar has gone down a lot," says Adrian Lee, president of Adrian Lee & Partners, which oversees $6 billion of currency and fixed-income investments. "But it's only a matter of time before it will turn higher again."
The Fed is unique among its counterparts in Japan, the U.K., Australia and the euro zone in that it has openly considered a policy of withdrawing monetary stimulus, Mr. Lee says. That alone is supportive of the dollar.
The relative health of the U.S. economy will continue to remain a lure, investors say. The International Monetary Fund pegs U.S. growth this year at 1.9%, compared with an average of 1.2% for all developed economies.
"What's the most attractive currency in the room? To investors, it's clear it's the dollar," says Akshay Krishnan, a senior analyst at Stenham Asset Management in London. "The underlying view is that the U.S. economy is recovering and growing at a faster pace than other parts of the world."
Still, there are warning signs for the dollar. Yields on Treasurys rose sharply starting in May—for reasons also related to possible Fed tapering—with the 10-year yield hitting a nearly two-year high of 2.718% on July 5.
The soaring bond yields sparked record outflows in emerging markets, sending investors back to the refuge of the dollar. But the drop in bond prices, which move in the opposite direction to yields, has since abated. The yield on the 10-year Treasury was 2.58% Friday.
Christopher Brandon, a managing director with Rhicon Currency Management (Pte.) Ltd., believes Treasury yields will have to rise above 3% before another upswing in the dollar is triggered. He says that is unlikely until the Fed actually starts tapering. "The market found that it got a little bit ahead of itself" in its optimism on the dollar, said Mr. Brandon, who manages about $500 million in Singapore.
A sustainable rally probably won't emerge for several months, says Stephen Jen, founding partner of London hedge fund SLJ Macro Partners LLP.

"The dollar needs confirmation that this economic divergence is indeed playing out," Mr. Jen said. "We need to see better data in the U.S., and we need to see weak data in the rest of the world. If this thesis is undermined, then the dollar will struggle."