June 5 (Bloomberg) -- Investors may benefit from selling the U.S. dollar against the currencies of Norway and Canada, which are likely to strengthen the most as the greenback weakens on concerns about the U.S. budget deficit, Morgan Stanley said.

The dollar may drop to 5.50 krone, the weakest since September, within six months, wrote Sophia Drossos, co-head of global currency strategy at Morgan Stanley in New York, in a note to clients. Investors who bet on such a slide should exit the trade if the dollar rises to 6.60 krone, she said.

“We continue to recommend shorting the U.S. dollar against cyclical currencies with strong balance sheets, such as the Norway Krone and Canadian dollar,” Drossos said in the note yesterday. The krone’s “valuations do not look stretched compared with other commodity-sensitive currencies and it is our strongest-conviction view versus the U.S. dollar.”

The U.S. dollar rose 0.4 percent to 6.3122 krone at 11:30 a.m. in Tokyo. The krone’s 13 percent gain against the greenback over the past three months lags behind 11 of the 16 most-traded currencies. It is also less than half the advances posted by the South African rand, the New Zealand and Australian dollars and Brazil’s real, also commodity-backed currencies.

The dollar weakened against each of the 16 most-active currencies since March 5 as concerns intensified about the nation’s ability to fund a record budget deficit.

Budget Deficit, Inflation

The difference between two- and 10-year Treasury yields yesterday widened to a record 2.793 percentage points, indicating that investors are demanding more to lend to the U.S. government for longer periods as they fear inflation will erode the value of their bond holdings.

Pacific Investment Management Co., which runs the world’s biggest bond fund, said investors should favor short-maturity debt for the next three to five years and buy outside the U.S. as the nation’s borrowing increases.

“We expect the U.S. budget deficit to become more of a U.S. dollar headwind amid some emerging signs of reduced willingness by foreigners to finance it,” Morgan Stanley’s Drossos wrote. “Financial markets may be reflecting more concern that accommodative policy could overstay its welcome and generate future inflation.”

To contact the reporter on this story: Candice Zachariahs in Sydney at czachariahs2@bloomberg.net

Last Updated: June 4, 2009 22:54 EDT