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Taper talk sets tone for down and out dollar

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As the dollar languished near eight-month lows on Friday, currency strategists say the U.S currency could head lower still as markets push back expectations for a tapering of the Federal Reserve's monetary stimulus.

The dollar index, which measure's the greenback's value against a basket of other major currencies, stood at about 79.71. It held within sight of eight-month lows hit Thursday as investors weighed the fallout of the crisis in Washington that ended a day earlier with a deal to reopen the government and avert a debt default.

On Friday, the Chinese yuan extended its rally to a new record high at about 6.09 per dollar, putting it on track for its biggest weekly gain in over a year.

(Read more: 'Unnecessary damage' to economy from shutdown)

Economists say that the 16-day partial shutdown of the U.S. government and uncertainty over the next round of budget and debt ceiling talks early next year could encourage the Fed to keep its asset-purchase program in place for longer than anticipated to support the U.S. economy.

"We think the dollar is headed lower. The debt ceiling deal that was concluded has delayed any possible Fed tapering," said Michael Woolfolk, managing director and senior currency strategist at BNY Mellon.

"Some are now talking about tapering not happening until late 2014 and possibly early 2015. This undermines the U.S. dollar in terms of interest-rate differentials and growth differentials," he said.

(Read more: Why the shutdown could mean no tapering this year)

The dollar index is down almost 6 percent from a three-year peak hit in early July when expectations for Fed tapering triggered a rally and fueled talk of a new era of strength for the dollar.

But a lot has changed in the past few weeks, with some analysts questioning the dollar's status as the world's top reserve currency in the wake of the crisis in Washington.

3-month chart of U.S. dollar index

Ray Attrill, co-head of foreign exchange strategy at National Australia Bank, said that if the dollar index breaks below 79.50 it could head down to around 78 – implying a fall of around 2 percent from current levels.

(Read more: Debt deal done, but dollar's demise deep-rooted)

Michael Mattiussi, coporate FX dealer at Western Business Solutions, said the euro meanwhile could be set up for further gains against the dollar if it can hold above $1.36 over the next few weeks. The single currency hit an eight-month high at $1.3681 on Thursday and hovered around $1.3660 on Friday.

Growth in question

Economists have revised down forecasts for U.S. economic growth in the fourth quarter of the year following the budget stalemate that triggered a partial shutdown of the U.S. government.

A Reuters poll released on Thursday showed analysts expect the U.S. economy grew at a 2.3 percent annualized rate in the final three months of the year, down from a previous forecast of 2.5 percent.

"For the dollar, it's all about the tapering debate right now," said Attrill at NAB, adding: "There has been an undeniable shift in thinking on tapering after the debt ceiling crisis. The idea that the U.S. economy is going to outperform is being questioned and in this environment the dollar will struggle."

(Read more: 'Taper talk' may be dead until next year)

Mattiussi at Western Business Solutions said that although Fed tapering appeared to be delayed for now, a scaling back of the central bank's stimulus program remained on the table and that boded well for the dollar further out.

"In the short-term there is a lot weighing on the U.S., but tapering will happen, it's just a matter of time," he said.

— CNBC.Com's Dhara Ranasinghe; Follow her on Twitter @DharaCNBC

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