The dollar is likely to extend gains in the upcoming week, continuing to draw support from growing signs of a stable U.S. recovery as well as a Federal Reserve plan to wind down most of its emergency lending early next year.
Both factors have pushed the market's U.S. interest rate expectations forward despite pronouncements from the Fed that it will keep interest rates low for an extended period.
The rate futures market on Friday has priced in at least one quarter-point rate increase by the beginning of the second half next year. A few months ago, futures traders had factored in Fed tightening late in 2010.
We see the U.S. economy continuing to recover and monetary policy settings starting to move back to normal, said Nick Bennenbroek, head of FX strategy at Wells Fargo in New York.
Although our economics team does not expect actual rate tightening to take place until late in 2010, the withdrawal of non-conventional measures could start tipping the scales in the dollar's favor, he added.
Year-end factors are also expected to contribute to dollar gains next week, analysts say, as investors continue to square up their portfolios.
Assets that have gained over the course of the year such as stocks, commodities, and emerging market currencies have come off going into the year-end on profit-taking and this has benefited the dollar.
The ICE futures' dollar index .DXY , a measure of the greenback's value versus six major currencies has been rising since early December although it has fallen 4.3 percent so far during the year, and has dropped about 13 percent since March.
On the week, the dollar index is up 1.9 percent, its best weekly performance since April.
The euro EUR=, on the other hand, was down 2.4 percent this week versus the dollar, on pace for its worst weekly showing in eight months. On Friday, it fell to $1.4269, the lowest since early September.
Analysts said the euro stands to lose most as the dollar gains given persistent fiscal problems in Greece.
The S&P ratings downgrade on Greece and continued widening in Greek sovereign CDS spreads triggered a break of the recent tight ranges in the euro.
The euro is feeling the ill-effects of ongoing strains in Greece and we doubt that this euro-negative factor will soon abate, said Todd Elmer, currency strategist, at CitiFX in New York.
In terms of economic data, the U.S. calendar is relatively packed despite a holiday-shortened week. The final estimate for U.S. gross domestic product in Q3, a slew of housing data, and reports on personal income and spending including durable goods orders are all due next week.
The reports may move the market especially given thin volumes, but more important, the numbers are likely to support the view that the U.S. economy is on a steady path to recovery.
That should further underpin the dollar, which of late has moved in line with U.S. economic fundamentals and interest rate prospects. The more upbeat the U.S. data, the more investors buy the U.S. dollar.
In other currency pairs, dollar/yen next week is expected to catch up with the broader rally in the greenback. Analysts say the Japanese economy continues to lag that of the United States.
Given a deflationary backdrop, weak Japanese activity is likely to keep pressure on the Bank of Japan to maintain its extremely accommodative stance, which should see interest rate spreads move against Japan as global central banks raise rates.
CitiFX this week went long the dollar versus the yen, with a target of 96 yen.