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US dollar set to take hit from ECB tapering

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US dollar set to take hit from ECB tapering

An expected tapering of asset purchases by the European Central Bank could be about to trigger a more pronounced period of dollar weakness, currency analysts said.

Fresh off the U.S. Presidential elections, the dollar hit a peak in late December 2016, with the U.S. Dollar Index at 102.210. Not only were there reasonable expectations that a Republican-controlled federal government could enact a business-friendly agenda, but the rest of the world was still playing catch up.

That story has changed, said Eric Viloria, currency strategist with Wells Fargo Securities.

"We are expecting the dollar to be in a multi-year depreciating trend," Viloria said in a recent interview. "The key factor behind U.S. dollar weakness is that other central banks are becoming less accommodative as growth picks up in the rest of the world."

Indeed, with the European Central Bank expected on Oct. 26 to review a timetable for reducing its bond buying program, the time may be at hand.

"While an announcement of a further reduction in the pace of bond purchases is widely expected, there is uncertainty regarding the size and timing of any further reduction in the pace of asset purchases," Wells Fargo Securities said in a recent research note.

"We're expecting EUR/USD to get up to 1.30," Viloria said. The EUR/USD was at 1.1765 on Oct. 24.

Rising pressure

The ECB's move away from monetary stimulus "is boosting the euro and putting pressure on the dollar," said OANDA senior currency analyst Alfonso Esparza.

With spreads on 2-year U.S. Treasurys and German bunds of the same duration at an all-time high, a strengthening eurozone economy would mean narrowing spreads, which would put additional downward pressure on the dollar, Esparza said.

The dollar hit its last peak in mid-2010, with the Dollar Index at 86.019, strength largely attributable to the Greek debt crisis, Invesco global markets strategist Kristina Hooper said, with assets flowing to the U.S. "looking for yield and safety."

Before that, the dollar peaked at 119.470 in mid-2001, when the Fed was cutting interest rates faster and to a greater extent than other central banks, "even if the currency move lagged the interest rate move," Viloria said.

The U.S.' current account deficit as a percentage of GDP is also on the rise, which historically has weighed on the dollar. In the second quarter it was $123.1 billion, or 2.6% of GDP, up from $113.5 billion or 2.4% of GDP in the first quarter, according to the Dept. of Commerce.

The big unknown is who President Donald Trump will nominate to be the next chairman of the Federal Reserve. If he were to replace Janet Yellen with someone perceived as more hawkish – Stanford University economics professor John Taylor is one of the front runners along with Fed governor Jerome Powell – then the dollar bull run may continue.

"If we see a new Fed chair who continues to be more hawkish, my expectation is that the dollar will be upwardly biased," Hooper said.