Currencies

Don't jump on the dollar bandwagon, just yet

Why this FX expert is modestly bullish on the dollar?
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Why this FX expert is modestly bullish on the dollar?
No Asian recovery if dollar strengthens: Julius Baer
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No Asian recovery if dollar strengthens: Julius Baer
The strong US dollar impact
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The strong US dollar impact

The greenback's had a banner year and while most investors predict the rally to continue to 2016, gains may be more modest than expected and that could soothe emerging market currencies.

The U.S. dollar index (USD) is poised to end 2015 with a more than 9 percent increase as expectations for the Federal Reserve to begin a tightening cycle boosted buying in the months leading up to the central bank's historic December meeting.

Now that the Fed has lifted rates and central banks in Europe, China, Australia and Japan remain more likely to provide more stimulus, the divergence in global monetary policy is expected to further underpin the dollar.

But nearly a week since the first U.S. rate hike in a decade, the dollar recorded its fourth straight session of losses on Wednesday. That's providing relief to battered emerging market currencies: The Indonesian rupiah spiked 1 percent on Tuesday to a one-month high, notching a fourth straight day of gains, while the Indian rupee is also trading close to its best levels in nearly a month.

Several market players, including Citi and National Australia Bank, are anticipating only around 5 percent gains for the dollar next year, compared to Deutsche Bank's 10 percent.

"We're no longer in a position where we have very stretched long dollar positioning among the speculative market," Ray Attrill, co-head of FX strategy at National Australia Bank told CNBC this week, citing IMM's positioning data published on Friday. A long position is a bet that profits from an increase in the price of an asset.

The Fed hike will hit these two currencies

"A month ago, the market had 400,000 outstanding speculative dollar-longs against G10 currencies. That's now come down to 250,000 so that tells me that we aren't going to start 2016 the same way we started 2015."

Historical evidence also supports the case for a milder rise in the dollar next year.

"It's intuitive that the dollar should go higher but if you look at the seven past Fed rate hike cycles, it tends to weaken after the first hike and doesn't strengthen afterwards," noted Mark Matthews, head of research Asia at Bank Julius Baer.

Because of this trend, investors may want to consider getting into beaten-up emerging market (EM) currencies, Hayden Briscoe, director of APAC fixed income at AllianceBernstein, told CNBC last week.

"We're probably not going to rally back to the old highs, but we could be looking at a 10 percent mean reversion," he said, referring to EM currencies overall.

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Many EMs, including Brazil, Russia, Malaysia and Indonesia are commodity exporters so the impact of a rising greenback on global energy prices has dealt a harsh blow to growth and government revenues.

Moreover, soaring valuations alone could limit the greenback's rally.

"The trade-weighted dollar is close to its absolute historical average and has climbed above its 10-year moving average. It also appears notably overvalued against a number of currencies, including the euro," warned Rebecca Paterson, chief investment officer at Bessemer Trust, in a recent report.

Regardless of whether the gains are gradual or rapid in the first few months of 2016, the party is sure to stop by July, pointed out Kathy Lien, managing director at BK Asset Management, in a Monday note.

"In the second half of 2016, we believe rate hikes and the strong dollar will force the Fed to slow tightening, marking the top for the greenback and the bottom for other currencies."

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