Oct. 23 (Bloomberg) -- ``The dollar is not yet out of the woods,'' UBS AG strategists told clients in an Oct. 2 report, as the currency traded higher against the euro and yen than the firm had predicted. The dollar would weaken ``sooner rather than later,'' they wrote.

Within days, they were eating crow. By Oct. 16, UBS had twice raised its one-month dollar forecasts to 119 yen and $1.24 to the euro, up from 114 yen and $1.30. It also raised its three- month dollar estimates. ``Dollar to stay stronger for longer,'' the bank was telling clients.

UBS and Merrill Lynch & Co. have been surprised by the U.S. currency's strength this year. They're betting that traders in the more than $2 trillion-a-day global foreign-exchange market will come around to their view on the dollar as the world's economy cools off.

``As investors have become more positive on global growth, the dollar has managed to confound the long-term bears,'' said Mansoor Mohi-uddin, global head of foreign-exchange strategy at UBS in London. ``The dollar will do well while such sentiment lasts; but once financial markets shift towards pricing in slower global growth, the dollar will start to weaken again.''

A slowdown in the U.S. housing market will weigh on the economy, prompting the Federal Reserve to cut its benchmark interest rate to 4.25 percent from 5.25 percent now, the firm says. The Fed raised borrowing costs 17 consecutive times between June 2004 and June of this year.

Bearish Majority

Lower interest rates would make the U.S. currency relatively less attractive. In a year, Mohi-uddin predicts the dollar will be changing hands at $1.40 per euro -- or 9.9 percent weaker than its current $1.2608 -- and at 100 yen, 16 percent weaker than last week's close of 118.75 yen.

He's got plenty of company. In foreign-exchange forecasts compiled by Bloomberg News, 32 of the 42 projections have the euro at $1.28 or above by year end, and 22 of the 42 see it at $1.30 or higher. By contrast, only six have the euro trading at $1.25 or lower by Dec. 31.

Meanwhile, 26 of 42 forecasts see the dollar at 115 yen or weaker by year end, while only four of 42 predict it will be at 120 yen or higher.

``A large part of the foreign-exchange market, including ourselves, is bearish on the dollar,'' said Steven Englander, head G-10 currency strategist at Merrill Lynch in New York.

Growing Economies

``The European and Japanese economies are in the upswing; the market is underestimating how high and how fast their central banks will raise interest rates,'' he said. ``Right now, investors are pretty much ignoring the good economic stories in Europe and Japan.''

The European Central Bank's benchmark rate stands at 3.25 percent, having been increased by 1.25 percentage points since December. The Bank of Japan raised its key overnight rate to 0.25 percent from almost zero in July, its first increase since August 2000.

Merrill Lynch economists say the Japanese central bank will again raise its rate 25 basis points in the fourth quarter. Englander said the market doesn't have an increase fully priced in until February or March. Similarly, Merrill expects the ECB to raise its rate in two steps to 3.75 percent by the end of the second quarter. The market doesn't have a second ECB increase fully priced in during 2007, said Englander.

A weaker dollar makes U.S. companies more competitive on world markets, which can translate into fatter earnings. It may also add to inflation by raising the cost of imported goods, which in turn can mean higher U.S. interest rates than otherwise.

Dollar's Effect

Furthermore, the dollar's exchange rate affects investment returns. For instance, from Oct. 25, 2000 -- when the euro reached a record low against the dollar -- through last week, the euro soared 53 percent against the dollar. The dollar rose 9.7 percent against Japan's currency.

An American investor in the Morgan Stanley Capital International Euro Index had a gain of 26 percent in dollars and a Japanese investor earned 39 percent in yen, while a resident of one of the 12 countries that use the euro suffered a 17 percent loss. MSCI's USA index fell 0.9 percent in dollars, rose 9.2 percent in yen and tumbled 35 percent in euros.

Englander said traders and investors had been focusing on interest-rate spreads between different currencies and low currency volatility, ``which taken together suggests that buying high-yielding currencies such as the dollar, and selling low- yielders such as the yen, is a low-risk trade.''

Currently, an investor can borrow yen for three months at an annual 0.45 percent rate, convert the yen to dollars and deposit the dollars in an offshore account at 5.3 percent.

Trade Deficit

Englander noted that the dollar hadn't declined even as the U.S. reported two consecutive record monthly trade deficits: $68.0 billion in July and $69.9 billion in August. ``Eventually the dollar's problems will reassert themselves, but at the moment, the market isn't paying attention to them,'' he said.

Still, the dollar has strengthened. On Oct. 13, it rose to a 10-month high 119.88 yen and $1.2484 to the euro, its strongest since July 19.

Investors are flocking to dollars in part because U.S. government fixed-income securities are attractive, said Alan Ruskin of RBS Greenwich Capital Markets Inc. The yield on three- month Treasury bills, 5.08 percent, is higher than the 4.78 percent yield on the 10-year government note.

That means bills offer ``risk-free opportunities,'' while 10-year notes look attractive because investors perceive the Fed as credibly controlling inflation, said Ruskin, chief international strategist at the firm in Greenwich, Connecticut. Inflation erodes returns from fixed-income investments.

International investment in U.S. securities rose to a record $116.8 billion in August from $32.9 billion a month earlier, the Treasury Department reported last week.

``People feel more comfortable that growth won't fall out of bed entirely and that equally inflation won't take off to the point where it severely undermines the U.S. bond market or U.S. equities,'' said Ruskin. ``Between year end and early 2007, the risks are towards a stronger dollar.''

To contact the reporter on this story: Michael Sesit in Paris at msesit@bloomberg.net

Last Updated: October 22, 2006 19:26 EDT