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.

EUROLAND SURPRISE

Germany and France both returned to growth in the second quarter. Other data showed the euro zone service and manufacturing sectors improved more than expected in August.

Meanwhile, the leading economic index of the Organization for Economic Co-operation and Development suggests stronger momentum for the euro zone, said Richard Franulovich, senior currency strategist at Westpac in New York, with the difference between the two currently at multi-year highs.

However, the current consensus forecast for the euro/dollar, as well as options and speculative positioning in the pair, suggest that the market may not have fully priced in that story.

There is an under-appreciated and under-owned near term Euroland recovery story highlighting potentially significant short-term upside risk to the euro/dollar, said Franulovich.

Next week, the ECB will upgrade its outlook for the euro zone economy this year and in 2010. Separately, a Reuters survey found that economists now believe the ECB will start raising rates in the third quarter of next year, rather than the fourth quarter.

DOVISH FED

There's growing evidence that the link between the dollar and risk appetite is fading. Earlier this month, the greenback rallied on news of a much slower pace of U.S. job losses in July. In recent months, the dollar has tended to rise on bad economic data as investors saw it as a safe-haven.

For the time being, though, risk sentiment is still a key driver for currencies as uncertainty remains over how the recovery is going to unfold.

The market still remains relatively confused, said Boris Schlossberg, director of currency research at GFT Forex in New York. The question is: is the rebound going to be sustainable as we go into the third quarter? That's why you see very range-bound conditions in the currency market.

High unemployment and the output gap, or the difference between current and potential production, will deter the Fed from unwinding its stimulus policy prematurely. Many analysts expect U.S. rates to stay near zero for most of 2010.

It's now cheaper to borrow in dollars than in the yen with two- and three-month dollar Libor dipping below their Japanese equivalents for the first time in 16 years this week.

As the output gap remains, it's very difficult to see inflationary pressures build, said Paresh Upadhyaya, portfolio manager at Putnam Investments in Boston.

(Bernanke) is likely to err on the side of caution. The Fed has room to keep interest rates low for a prolonged period of time and that will be the main reason to prevent a sustained recovery in the dollar.

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