Fed nerves weigh on 'crowded' dollar trade

Nervous investors sent the dollar lower on Tuesday ahead of what many expect to be a dovish message from the Federal Reserve Wednesday, as new data shows the "long dollar" is three times more crowded than any other trade.

The Fed is widely expected to raise the Fed funds rate by a quarter point Wednesday for the first time since June 2006, while emphasizing that it will be slow to hike rates further. But any hints it could raise rates less gradually could boost the dollar.

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"Bulls are long the dollar, bears are long the dollar," Bank of America Merrill Lynch said on Tuesday, with more than half of the fund managers surveyed by the bank now calling long U.S. dollar, or expectations of further strength, the "most crowded trade," up from over 30 percent in November.

"The strong dollar view is writ large across all asset, regional and sector allocations. It will take a very dovish Fed and weak U.S. earnings to reverse the strong dollar view in 2016," said Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research.

Over a third of investors surveyed between December 4 and 10 predicted the end of the Fed hiking cycle is the event most likely to end the U.S. dollar bull market.

But traders got nervous on Tuesday about what the Fed might say about the future path of interest rates and sent the dollar to a seven-week low against a basket of currencies. The dollar index fell to a low of around 97.19, while the euro traded around $1.0997 against the dollar.

"Weakness in commodity prices, emerging market assets, U.S. high yield investments, and the renminbi are all resulting in more risk-averse trading conditions encouraging a further lightening of long U.S. dollar position," said currency analyst at Bank of Tokyo-Mitsubishi, Lee Hardman.

"Long U.S. dollar positions are likely to be lightened further ahead of the upcoming FOMC meeting given the risk that the Fed may overcompensate for raising interest rates for the first time since June 2006 by providing more dovish than expected communication. However, a "dovish" rate hike from the Fed is well anticipated and US dollar weakness already in advance of the FOMC meeting should help to dampen the scope for any further weakness," he added.

As well as expecting a stronger greenback, almost 60 percent of the 215 fund managers, managing a total of $620 billion under management polled by BofA ML forecast the Fed will raise rates three times or more in the coming year.

"I expect the Fed to remain prudent and cautious yet pragmatic over the next year. I think the Fed has capacity for three rate hikes between now and the end of next year with the Fed funds rate rising by 75 basis points from current levels by the end of 2016. The U.S. will experience modest economic growth, slightly above 2 percent and consumer spending will drive much of that growth," global head of high yield at asset management firm Alcentra, Chris Barris said.

Meanwhile, allocation to U.S. stocks fell to 8-year lows, after fund managers have held underweight positions in U.S. equities for 10 straight months.

The Fed begins meeting Tuesday, and will release its post-meeting statement Wednesday at 2 p.m. ET, where Fed chair Janet Yellen is likely to try and assuage fears of a rapid pace of rate hikes by stressing that further hikes will be "data dependent" at the press conference following the decision.

"This phrasing will allow market participants to assume anything they want about the pace, with many likely to assume that implies a gradual pace. This should be reflected in the "dot plot", which is suggesting a historically gradual pace of 100 basis points but which is still likely to continue to point toward more hikes in 2016 than the market is currently pricing," said economist at UBS, Drew Matus.