U.S. dollar bulls may be hobbled by economy

The U.S. economy has been improving, and dollar investors are starting to take notice. But punters who bet on more greenback gains from stronger U.S. economic data and interest rate hikes could be disappointed.

Having been largely driven by swings in risk sentiment over the past year, the currency market is slowly refocusing its attention on growth and yield differentials as the global recession nears an end.

This has stoked the enthusiasm of dollar bulls, who argue that a U.S.-led recovery and potential interest-rate increases by the Federal Reserve would boost the appeal of the dollar over other major currencies.

But Europe may have beaten the United States to the punch. While the U.S. economy is showing signs of stabilization, recent data out of the euro zone has been more encouraging.

It raised speculation that the European Central Bank may start tightening monetary policy before the Fed.

"The risk of a surprise for the market could be that Europe does indeed recover more quickly and that the ECB may not feel the need to wait for the Fed," said Adam Boyton, senior currency strategist at Deutsche Bank in New York. "That would be an environment that would be particularly negative for the dollar."

The prospect of the Fed lagging behind other central banks in hiking rates is a source of worry for the dollar. Risks are rising the greenback could become the primary funding currency in the so-called carry trades, a distinction long held by the Japanese yen. In such trades, investors borrow in low-yielders and reinvest in assets with greater returns, putting yet more pressure on currencies with low interest rates.