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The declining dollar: Why everyone got it wrong

Olena T | iStock | Getty Images

2014 was supposed to be the year of the dollar, a breakout for the currency.

It was a no-brainer—the U.S economy was outperforming developed markets like Europe and even emerging markets like China and India. The Federal Reserve was finally starting the "taper," or the scaling back of the massive, unprecedented amount of easy money that's diluted the dollar's value for the last few years. At the same time, central banks in Japan and Europe are looking to ease further.

For all of these reasons, strategists from JPMorgan Chase to Morgan Stanley to UBS predicted 2014 would kick off with a stronger dollar.

But so far, the U.S. currency has gone in the opposite direction.

The dollar index—a measure of the currency against a basket of its global competitors—is trading below the critical 80 mark, the lowest level since last October. The euro has soared to a seven-week high, and the British pound is hovering at the highest point since August 2009.

And it's not just the strategists that have been wrong. Futures traders also have been trimming their losing bearish bets as the currency has weakened. Speculators have been shorting the dollar, with the value of that short position at $686 million last week, significantly lower than $1.58 billion in the prior week, according to data from the Commodity Futures Trading Commission

Why?

One factor is the surprisingly lower Treasury yields; the dollar tends to track yields, especially the dollar-Japanese yen trade.

Like the dollar, Treasury yields are also confounding consensus, actually falling because of weaker-than-expected economic signals. Those include first quarter gross domestic product (0.1 percent, with most economists projecting revisions that will make that number negative), and other worrisome spots in the economy, such as a declining labor force participation rates and low inflation. These factors could temper Fed Chair Janet Yellen's enthusiasm for the economy and a likely move in 2015 toward higher interest rates.

Read MoreHow QE may be doing more harm than good

Another reason traders cite: Strong demand for European assets, particularly debt of euro zone periphery nations including Spain and Italy.

Spanish 10-year bonds have been hot lately, with the yield dropping below 3 percent for the first time ever after trading above 14 percent at one point during the region's debt crisis. In other words, money has been rushing into those bond markets in euros.

"The (currency) market will probably react more to that (demand for European assets), than to any further move in relative rates," said Kit Juckes, currency strategist at Societe Generale,

Bottom line: Tapering isn't having the tightening effect that was predicted, both on on the dollar and on Treasurys.

"The wide consensus entering the year of Fed tapering equaling a stronger U.S. dollar has not come to fruition because on the stage of (quantitative easing), the Fed's balance sheet is only exceeded by the (Bank of Japan) as a percent of GDP," wrote Peter Boockvar of The Lindsey Group.

So what now?

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Technically speaking, "if the dollar index continues to fall and breaks through 78.85, there is no major support until 76," said Kathy Lien of BK Asset Management.

Fundamentally speaking, strategists say it will take a much stronger economy, and therefore higher interest rates, to move the dollar higher—which, at least at the moment, doesn't appear to be imminent. Until then the dollar could continue its weakening ways.

Short-term risks for dollar bears include any mention of higher interest rates or enthusiasm for the economy from Yellen in testimony on Capitol Hill Wednesday and Thursday or easier policy from the European Central Bank on Thursday.

Read MoreYellen expects strong growth this quarter

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