Investors will continue to demand a risk premium on the U.S. dollar heading into 2014, though some remain optimistic that Washington may reach a lasting solution to the debt impasse early next year, restoring some confidence to the battered greenback.
This month's bruising political standoff over the U.S. budget combined with the acrimonious debate over extending the U.S. government's $16.7 trillion debt limit shut down non-essential government services and hit growth expectations for this quarter.
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Those heightened perceptions of sovereign risk, which tarnished the dollar's reputation as the world's reserve currency and boosted the appeal of the British pound, Australian dollar and the once-ailing euro, said Sean Callow, Senior Currency Strategist, Westpac Bank.
And while U.S. political tail risks haven't "undermined the dominance of the dollar completely, it has still encouraged diversification into other currencies such as [the euro]," said Kathy Lien, managing director at BK Asset Management.
Although recent European economic data including Germany's IFO business morale index printed below forecasts, the single European currency only fell modestly from two-year highs of $1.3833, suggesting investors still favor the euro over the dollar, Lien said.
Still, the dollar index staged a mini-recovery early Wednesday in Asia, trading at one-week highs after breaching 79.00 on Friday to sink to a nine-month low. The dollar may continue to mend if the political environment in the U.S. is more constructive heading into 2014, said Mirza Baig, head of currency and interest-rate strategy in Singapore at BNP Paribas.
"The debt ceiling fiasco was a major blow to U.S. standing in the world, and raised new questions about the dollar's reserve currency status," Baig said.
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"However, I think the Republican Party must have learnt that there is little to be gained from further grandstanding on this issue. As such, we may get a lasting solution to the U.S. debt ceiling issue in February, which should help restore some prestige for the USD."
Though U.S. Democrats and Republicans reached an 11th-hour agreement to break the fiscal impasse, the deal only funds the government until Jan. 15 and raises the borrowing limit through to Feb. 7, setting the stage for possibly another showdown and possibly more turmoil for the U.S. currency.
Against such an uncertain background, "some investors are clearly thinking about whether the dollar needs a political risk premium attached to it," said Jens Nordvig, Global Head of G10 FX Strategy at Nomura.
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Officials "from the Eurozone to China…have expressed concern about the special status of U.S. securities and the need to revise current structures," Nordvig said in a research report earlier this month. "This calls into question the reserve currency status of USD, even if it is hard to find a good alternative in the short term."
— By CNBC's Sri Jegarajah. Follow him on Twitter: @cnbcSri