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Currency experts can't figure out what's going on with the dollar

The rise of the dollar in recent weeks has analysts scratching their heads. Even those who predicted it would be strong wonder why now.

With little to move on after the Federal Reserve announced it would leave U.S. overnight interest rates unchanged on Wednesday, the dollar remained near its highest level of the year. In just the last few weeks it has taken back lost gains against world currencies like the euro, British pound, Japanese yen and other global stalwarts.

But many currency strategists can’t rationalize why the greenback has come back into style.

Certainly, U.S. Treasury yields have hit new highs, American data prints have been solid, and the Federal Reserve looks poised to continue raising U.S. interest rates this year. But none of this is news. In fact, analysts say the Fed’s rate hike path has been baked into the cake for some time now on expectations for continued strength in U.S. growth and inflation readings.

Either completely wrong or very early

The Fed raised rates three times in 2017, taking U.S. rates to between 1.25% and 1.5%. That was already significantly higher than the zero interest rate held by the Bank of Japan and European Central Bank, which even hold negative rates for some deposits.

As the U.S. rates moved higher, with other major central banks (including the Bank of England) at a standstill, the dollar only trudged lower, falling by around 10% in value last year. That trend had continued in the early months of 2018, but then reversed sharply.

“I’ve been thinking the dollar would strengthen for a lot of last year and certainly the first part of this year, so those two calls were completely wrong or maybe I was just very, very early,” said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington. “That said, I think that the stars are aligning here for a continuation of the dollar’s strength, barring any major surprises.”

Esiner’s forecast, however, goes against the grain as many analysts expect the dollar to end the year lower and have found it difficult to explain the recent strength. A recent survey of analysts by Bloomberg shows the dollar is expected to finish the year weaker against eight of the G-10 currencies.

(Yahoo Finance)

“Right now my bias still goes toward a weaker dollar,” said Sireen Haraji, currency strategist at Mizuho Corporate Bank in New York. “I’m not sure this recent pop-up is really going to be sustainable given high uncertainty in the U.S. economy and the fiscal outlookSo I’m not so sure that there is enough there to keep momentum going for the dollar.”

Trading data shows the market is strongly bearish on the greenback, with net-short dollar bets sitting at around $20 billion in the latest Commodity Futures Trading Commission data. Traders have been net-short the dollar – meaning they are betting its value will fall rather than rise – since mid-July of last year. A wider measure of dollar positioning that includes the New Zealand dollar, Mexican peso, Brazilian real and Russian ruble, showed a net short position of nearly $24 billion, down from $28 billion the previous week.

Much of the short bets against the dollar have been driven by an expectation that the European Central Bank will begin paring back its massive stimulus program that is injecting more than $30 billion into the economy each month sometime this year and that the Bank of Japan is likely not far behind.

Higher interest rates make currencies more attractive for investors to hold, but a jump in assets that are in an earlier stage of their investment cycle can be a stronger draw, analysts say.

But even that theory has been tested this year, as euro zone data has failed to take flight after strong readings last year, which investors worry could slow the pace of the bank’s drawdown in stimulus.

Axel Merk, president and portfolio manager at Merk Hard Currency Fund in Palo Alto, California, believes that much of the movement has been a result of mercurial traders.

“The dollar went up for four years and during that period interest rates weren’t really moving higher, there was just the talk. Then rates started moving higher and the dollar started to weaken,” Merk said. “We’ve had a lot of cross currents [this year] and people will interpret whatever story they want to interpret into these things.”

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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