NEW YORK (Reuters) - The dollar's perplexing summertime slump could prove tricky to reverse in the near term, given surprising signs of recovery in Europe and nagging questions about the timeline for the end of the Federal Reserve's stimulus.
The dollar index <.DXY>, which tracks the dollar against a basket of six major trading partners' currencies, slid to a two-month low this week and has now erased most of the 6.3 percent gain it had notched in the first half of the year.
Moreover, it has defied expectations for broad outperformance. According to a Reuters foreign exchange poll taken in February, the dollar was predicted to strengthen over the ensuing six months against four of the five dollar-index components included in the survey.
Instead, it has fallen against three - the euro, British pound and Swiss franc - missing median levels targeted by currency strategists and analysts by a wide margin. It has gained only against the yen and the Canadian dollar, the latter being the only currency against which it had actually been forecast to fall.
"The dollar we saw was based on the view of the time, supported by most of the data, that U.S. data was better than the rest of the world, that U.S. rates were higher than the rest of the world, and that the Fed was about to taper," said Jonathan E. Lewis, chief investment officer at Samson Capital Advisors LLC in New York, which oversees $7.2 billion in fixed income securities and currencies.
"Now that view is starting to unravel," Lewis said.
Questions about the strength of the U.S. recovery and how that will play into the Fed's thinking about when to scale back its $85 billion a month in bond purchases are dogging the dollar. Fed officials have sent mixed signals over the summer about their intent, at times indicating an eagerness to wind down the program and at others saying they will keep providing support as needed.
Weekly jobless claims are at a post-recession low, but upward momentum in job growth is elusive. U.S. employers slowed their pace of hiring in July to just 162,000 jobs, the smallest gain in four months. Given the U.S. economy grew by just 1.4 percent in the first half of the year, economists are worried that even that weak pace of job creation can be sustained.
"Federal Reserve Chairman Ben Bernanke's recent dovish comments and the mixed labor market report could continue fueling uncertainty among investors about when the Fed will taper its bond buying," said Tatjana Michel, director of currency analysis at the Schwab Center for Financial Research in San Francisco. "This uncertainty has the potential to undermine the dollar in the short term, especially if foreign economic figures keep coming in above expectations."
What is new is investors are seeing better opportunities elsewhere, particularly in Europe and the United Kingdom, as economic prospects there improve.
With stronger-than-expected growth in the currency bloc's largest economies, Germany and France, helping to haul the euro zone out of six consecutive quarters of contraction, analysts say a fragile recovery appears to be taking hold.
"It is likely that the dollar will continue to face headwinds if data in Europe continues to beat expectations by a greater margin than in the U.S," said Paul Lambert, who oversees $2 billion as head of currency at Insight Investment in London.
Investors are taking note, with the FTSEurofirst 300 index <.FTEU3> of pan-European stocks gaining 4 percent since July 1 versus a flat performance for the U.S. benchmark S&P 500 <.SPX>. That outperformance has helped fuel nearly $3.4 billion of inflows to U.S. funds invested in European stocks so far this quarter, according to Lipper data, putting the flow on track for its swiftest quarterly pace since the second quarter of 2007.
Britain's economic recovery is even further along and looks set to build on the 0.6 percent growth recorded in the second quarter of 2013. Employers have said they are hiring at the fastest pace since 2007, and though Britain's unemployment rate held steady at 7.8 percent in June, a sharp fall in jobless benefit claims in July pointed to a strengthening labor market.
The gap between U.S. and U.K. 10-year bond yields has contracted from around 30 basis points at the start of August to just 13 basis points now.
That's helped to push sterling to the front of the 36 most actively traded currencies against the dollar month to date, with a 3.1 percent rise. One pound currently fetches a rate of around $1.57, up from $1.50 six months ago and nearly 6 cents above the level forecast in the Reuters poll at the time.
As for the euro, the heaviest-weighted component of the dollar index, it too has outperformed expectations, gaining 1.7 percent year-to-date to last cross around $1.34. It was predicted to be trading below $1.30.
To be sure, most analysts do expect the dollar to resume its uptrend, but probably not until attractions like higher bond yields are more entrenched.
"In the shorter run, there will be three steps forward, two steps back," said Nicholas Pifer, Minneapolis-based head of global fixed income for Columbia Management, which has $341 million in assets under management. Investors will "have to see higher rates to have real sticking power" in the dollar's climb higher.
CHINA, JAPAN DUMP BONDS
Recent sovereign flows aren't helping the dollar either. Earlier this month the Treasury Department reported that China and Japan led an exodus from U.S. Treasuries in June on the heels of the first signals the Fed was preparing to dial back on quantitative easing.
The sales were part of $66.9 billion of net sales of long-term U.S. securities that month by foreigners, the fifth monthly outflow in a row and the largest since August 2007.
While U.S. benchmark 10-year Treasury yields are near two-year highs above 2.80 percent, which typically would be dollar supportive, investors are concerned that rising interest rates may lead to a broader sell-off in U.S. assets.
Currency speculators are also easing back on their bets on the dollar. Though speculators have been net long the dollar since February, the latest weekly data from the Commodity Futures Trading Commission showed they had pared those bets for a fourth straight week. [IMM/FX]
They also reversed course on the euro two weeks ago, becoming bullish after five straight weeks of being net short.
"The U.S. dollar was considered the cleanest shirt, whereas everything was horrible in Europe," said Axel Merk, president and chief investment officer of Merk Investments in Palo Alto, California. "Well, things aren't all that great here and not all that horrible there. As that reality settles in, the U.S. dollar might be under pressure."
(Reporting By Nick Olivari; Editing by Dan Burns and Dan Grebler)