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For investors who have enjoyed borrowing dollars cheaply to fund trades into higher yielding currencies and other assets, the futures market has a message - the party may soon be over.
Interest rate futures suggest US rates will rise above the euro zone's for the first time since 2001 sometime after the New Year, which analysts say will benefit the dollar against the single currency and could trigger more broad-based gains.
Higher US borrowing costs will make it more expensive to finance dollar short selling and hedges against future weakness, which can undermine a currency. It should also boost the attractiveness of dollar investments to foreigners.
"If the cost of hedging is increasing, even though it's anticipated that rates will converge, when they actually do it's going to change the behaviour pattern for hedging dollar risk," said Paul Mackel, currency strategist at ABN Amro.
"We are inclined to believe these types of investors - corporates, etc - will be less inclined to hedge their dollar risk. That will be very much a dollar positive factor against European currencies - not only the euro but sterling as well."
The short-term interest rate spread implied by the Eurodollar and the Euribor futures suggests US interest rates, currently at 1.25 percent, will converge with those in the euro zone by about December.
Catching up with rates of high yield currencies such as sterling is a more distant prospect, as discounted by Eurodollar and short sterling futures, but markets suggest the differential will halve by the end of next year.
FILLING THE GAP: Eurodollar December futures now see the Federal Reserve raising rates by at least another 75 basis points after starting to firm up in the wake of Fed chief Alan Greenspan's comments last week that recent weaknesses in the economy were transitory.
That amount of tightening would be exactly enough to bring the fed funds rate up to euro zone's current 2.0 percent.
"The cross of interest rates is around the end of the year, early next year," said Niels Christensen, currency strategist at Societe Generale in Paris.
"That's the main reason we have been calling for euro/dollar moving towards $1.15 at the end of the year."
After robust US consumer confidence data this week backed the firming in rate bets, the dollar gained to $1.1999 per euro on Wednesday, its highest in over a month.
Ian Stannard, currency strategist at BNP Paribas, said interest rate expectations should help push the dollar to $1.17 or $1.15 per euro in the coming months.
The flip in rates could see the dollar go from funding vehicle to the long side of carry trades eventually, said Peter Fontaine, currency strategist at KBC in Brussels.
"The ultimate barometer is the Fed's rate and if it's higher than the ECB then the dollar could be in for quite a rebound," he said.
"You could get a rebalancing of hedge funds, of longer term players reversing flows heavily from a current view of somewhat dollar underweight and you could go to dollar overweight. At that stage the market could go back to parity in euro/dollar. It's long-term, though, like in a year's time."
YIELD ATTRACTION: Recent European Central Bank policymaker comments that the ECB is not expecting to raise interest rates in the next few months suggest little in terms of obstacles to US rates overtaking the euro zone's.
Analysts caution that rising rates may not compensate for dollar-negative factors such as a persistently wide US trade deficit, which runs at more than $1 billion a day.
The Treasury Department's latest flows report highlighted such concerns, showing foreign investors sharply slowed their pace of investment into the United States in May.
But as rising rates become a reality, the dollar could gain serious momentum.
Once they pass the euro zone's and squeeze differentials with high yielders, this could put pressure on a range of trades funded out of short dollar positions - from emerging market debt and currencies to Asian equities and commodities.
"You've got quite crowded trades in a variety of markets that are vulnerable as US rates rise," said Steven Pearson, chief currency strategist at Halifax Bank of Scotland Treasury Services.
"Not only because it makes the funding costs of those positions higher but also because rising US rates actually reflect the fact that the US economy is going to deliver decent risk adjusted returns as it has done in the past."

Copyright Reuters, 2004

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