Treasury Secretary Hank Paulson's public support for a strong dollar on Tuesday failed to fully convince the foreign exchange market, which is now bracing for further weakness in the U.S. currency.

He repeated calls for more flexibility in China's currency policy - a veiled message to allow the yuan to strengthen and the dollar to weaken - but he also stressed the need for the world's fourth largest economy to make progress on other capital market reforms.

Alan Ruskin, chief international strategist with RBS Greenwich Capital, viewed Paulson's comments on China as slightly softer in tone than predecessor John Snow's, but ultimately leading to the same result: dollar weakness.

Comments on China included looking for FX flexibility, but giving them time to open their capital markets, is more conciliatory than the tone struck by the Treasury in the past, and to some extent takes immediate pressure off the Chinese to respond, Ruskin said.

Perversely this may result in a faster Chinese response, he added, implying that China might be more willing to allow the yuan to strengthen if it wasn't under a global spotlight.

In his first public comments since taking office last month, Paulson told CNBC in carefully articulated words that a strong dollar is in U.S. interests and currency values should be set in open and competitive markets - almost echoing word for word the utterances of the last three Treasury chiefs.

While Paulson's adherence to the stance of his predecessors was largely anticipated, the former Goldman Sachs chief executive had a more subtle message when it came to China.

The nuance there is that China has to deliver something: sooner or later stronger currency messages, which supports a weaker dollar, said Peter Frank, senior foreign exchange strategist with ABN AMRO in Chicago.

MORE CARROT, LESS STICK

Market participants were closely monitoring Paulson's first public appearance particularly since he had chosen not to endorse the U.S. administration's so-called strong dollar policy during his Senate confirmation hearings - unlike his predecessors Paul O'Neill and John Snow.

Currency traders initially reacted to Paulson's strong dollar comments by pushing the greenback slightly higher. But after finding few buyers at key technical levels, the dollar quickly reversed course and sold off across the board, hitting three-week lows against the euro and a two-month low against sterling.

After declining more than 30 percent in three years against a group of major currencies, largely due to the widening U.S. trade deficit, the dollar rose 13 percent last year, supported by a series of Federal Reserve interest rate increases.

This year the dollar is showing signs of weakening as the Fed could end its credit tightening campaign as early as next week, removing the dollar's crutch at a time when the trade shortfall has remained above $60 billion for nine consecutive months.

China's trade surplus is expected to reach $100 billion in September, nearly matching the $102 billion surplus of 2005.

Against this backdrop, the Treasury's strong dollar mantra is viewed by markets as toothless rhetoric.

I don't think it changes the fact that the U.S. administration would prefer a weaker dollar to help narrow the trade deficit, said Meg Browne, senior currency strategist with Brown Brothers Harriman in New York.

Browne also said Paulson's subtle approach could be more successful at getting China to speed up currency reform than a high profile bill sponsored by Sens. Charles Schumer and Lindsey Graham, which threatens stiff tariffs if Beijing doesn't significantly revalue the yuan by September 30.

Their approach is stick, not carrot, where he may be more carrot-focused, Browne said.

(Additional reporting by Steven C. Johnson)

China ABN Amro